Formula for working out interest

Interest is a fee paid for the use of someone else’s money. Interest is calculated on several formulas, but the most important one that you need to know, if you’re borrowing money, or have money in a savings account, is the Rule of 72.

Before we get to the Rule of 72, we’re going to define some terms. An interest rate is the percentage of the original amount of money that’s added to the balance (or charged to your account) each year. So, if you borrow 100 dollars at 5% interest, at the end of 1 year, you’ll owe 100 times 1.05 = 105 dollars. If you borrowed the money and paid it back over 2 years, you’d owe 100 time 1.05 times 1.05 = $110.25. As you can see, compound interest adds up pretty quickly!

When you take out a loan with a specified payment term (Say, 100 dollars, paid back in 2 years, at 5% interest), you’ll be making a payment each month for two years (24 payments total) with the sum equaling the 110.25 we derived earlier. That comes out to 110.25 divided by 24, or $4.59 per month.

Which brings us to the Rule of 72. Stated very simply, the Rule of 72 is a short hand way of doing compound interest. To find out how many years it will take for an loan’s interest to double the amount borrowed, divide 72 by the number of points of interest rate. For example, at 5% interest, you’d have 72/5, which is 14.4 – if you took 14.4 years to pay off that initial loan of 100 dollars, you’d end up paying a total of 200 dollars to your lendor.

Now, when you take out a certificate of deposit, or just put money in your savings account, the formula for interest works in your favor – to find out how long it will take your initial investment to double, divide 72 by your interest rate, and that’ll let you know what to expect. (This rule of 72 also illustrates why 401(k) with their employer matching funds, are such a good deal. When you contribute to your 401(k), your employer puts the same amount of money in – effectively doubling your investment instantly. With most annualized stocks averaging 8%, and most bonds hovering around 3-4%, you can see, by the Rule of 72, how much of a benefit that will be!)

The last thing to think about when you’re thinking about formulas for interest is inflation. To find out how much your nest egg is really growing by, subtract the inflation rate from your interest rate, then apply it to the Rule of 72. Thus, with inflation rates of around 3%, and investments getting about 8%, the net rate of increase is 8 minus 3 equals 5%, and 72 divided by 5 is about 14 to 15 years.