How to Calculate Monthly Compounded Interest

Banks pay you money for the use of your money. That's the idea behind savings accounts and certificates of deposit. How much your money earns is the interest rate. A simple interest rate is just the percentage of the money you invest that the bank pays you per year. If it's 6 percent, you'd be paid $60 for $1000 on deposit for a year. However, banks and other financial institutions don't wait an entire year before paying you any interest. Instead, it's divided into smaller amounts deposited periodically into your account. That's good for you, because then the added interest starts earning more interest---and that's what compound interest means.

Things You'll Need

• Calculator

Instructions

1. Figure the monthly interest rate. Divide the annual interest rate by 12. For example, if the annual interest rate is 6 percent, the monthly interest rate is 6 percent/12, or 0.50 percent. If you were calculating daily compounded interest, you'd divide the annual rate by the 365 days in a year instead of 12.

2. Multiply your principal, which is the amount on deposit, by the monthly interest rate and then add the result to your principal. For example, if you have $1000 on deposit, 0.5 percent of that is $5, so your new balance is $1005.00. To calculate monthly compounded interest for a year, you repeat this step 12 times, using the new balance from the previous month for each calculation (see Tips below).

3. Calculate monthly compound interest for the average balance in the account. You will probably make deposits or withdrawals from your account during the year. Your monthly interest is calculated from your average monthly balance when this happens. Start by subtracting any withdrawals from your starting balance, which is your "base principal." Next, for each withdrawal or deposit, find the number of days the money was on deposit. Then multiply the amount of the deposit/withdrawal by the proportion of days of the month it was in the account. For example, if you made a deposit of $100 that was in the account for 12 days in a 30-day month, you would multiply 12/30 times $100, for an average of $40. Add this amount to your base principal. Do this for each deposit/withdrawal to find your average balance.

4. Calculate your monthly interest by repeating Step 2 using the average balance. Finally, find your ending balance by taking your starting balance, adding and subtracting deposits and withdrawals, and adding in the interest earned for the month.

Tips & Warnings

• The formal equation to calculate monthly compounded interest is P1=P(1 + m)^12 where P is your starting or average balance, m is the monthly rate of interest, and P1 is the balance after monthly interest is added. In practice, almost all banks and financial institutions use computers to compound interest daily, rather than monthly. That's to your advantage since the more often interest is compounded the higher your effective interest rate will be. Trying to calculate monthly compound interest (not to mention daily) is more than a little tedious. Fortunately, there are good interest calculators available on many websites (see Resources below).

Resources

• Read this Article in Spanish
• Compound Interest Calculator