How to Calculate Compound Interest Loans

Interest is defined as the "cost of borrowing money." There are two types of interest, simple and compound. In compound interest, the interest amount is added back to the principal periodically so that future interest calculations include paying interest on interest.

Difficulty: Challenging

Instructions

1. Define your terms. Any interest calculation will require you define several terms. You will need to know the following: P equals principal. I equals interest rate (as a decimal). N equals the number of times that the interest is compounded in a year (monthly is 12 and quarterly four). T is the time expressed as the number of years for the calculation; and A is the answer after T number of years.

2. Plug your terms in to the follow formula: Divide I over N [I/N]. Add 1 [1+ (I/N)]. Multiply by P [ P(1+ (I/N)) ] and save this number. Multiply N by T [ NxT ]. Finally, raise the answer from 3 to the power of the answer to 4 [ans3^ans4].

3. Note the following example: P equals 1,000. I equals .1 (10 percent). N equals 4 (quarterly) and T equals 2. So the calculation is .1/4 = .025; 1+.025 = 1.025; 1,000 x 1.025 = 1025; 4x2 = 8 and 1,025 ^ 8 = 1,218.40. The figure 1,218.40 is the total paid for a $1,000 loan at 10 percent after two years with quarterly interest.

Tips & Warnings

• Writing down your terms separate from your calculation will make the concept easier to grasp.
• If you use 1 for N, it will turn the calculation into a simple interest formula.