If you’ve ever wondered how much money you’ll have at the end of a certain amount of time after investing in a fixed-income investment then this formula will come in quite handy. It’s called the compound interest formula and is actually quite easy to work with.
Future Return = P(1 + R)^T
Don’t be intimidated just because it looks like algebra, it’s actually quite simple. P stands for principal, R stands for you rate of return (interest rate) and T stands for the number of compounding periods that your money is going to be invested for. This formula is called the compound interest formula because it calculates the interest you’ll earn from the principal amount, as well as the interest you’ll earn on your earned interest (i.e. compound interest).
Let’s try it out, shall we? Let’s say you are going to invest $1,000 dollars in a 5 year certificate of deposit at an annual rate of 4% (compounded monthly). How much will you have at the end of the five years?
1000(1 + .04)^5 = $1,216.65
Can you see anything wrong with the way I calculated that number? The rate and the number of compounding periods is actually incorrect. If you’ll notice I said that the interest is compounded monthly. So what we need to do is divide the interest by 12 (12 months in a year) and multiply the number of years (5) by 12 months. Our updated formula should look like so:
1000(1 + .00333)^60 = $1,221
Does that make sense? It’s interesting that just by more frequent compounding you can actually earn several more dollars on your initial investment. You can use this formula with relative ease on any fixed-income investment (bonds, cd’s, etc.) to determine the end result from your initial investment.