calculate-compound-interest

Calculate Compound Interest

Apply the future value formula and Rule of 72 to project investment growth, illustrate the cost of delay, and solve for required savings rates.

Why This Is Best Practice

Adopted by: Compound interest calculations are foundational to every financial planning framework — used by CFPs, actuaries, and every personal finance curriculum (Dave Ramsey, Ramit Sethi, Vanguard investor education). The Rule of 72 is taught in every business school and CFA program as a mental math shortcut. Impact: Compound interest is the mechanism behind every retirement plan — not investment selection. Vanguard research shows that time in market explains 88% of the variance in long-term wealth outcomes; investment selection explains less than 5%. Understanding compound growth quantitatively transforms abstract future goals into actionable present decisions. Why best: Intuitive understanding of compound growth is systematically wrong — humans underestimate exponential growth. Calculating actual numbers (not approximate mental models) reveals that the cost of 5 years of delay is not 5 years of contributions but exponentially more — converting abstraction into urgency.

Steps

1. Future Value of a lump sum: FV = PV × (1 + r)^n Where PV = present value, r = annual rate (decimal), n = years. Example: $10,000 at 8% for 30 years → $10,000 × (1.08)^30 = $100,627.

2. Future Value of regular contributions (annuity): FV = PMT × [(1 + r)^n − 1] / r Where PMT = monthly contribution (use r/12 and n×12 for monthly). Example: $500/month at 7% for 30 years → $566,765.

3. Required monthly contribution to reach a goal: PMT = FV × r / [(1 + r)^n − 1] Example: Need $1,000,000 in 30 years at 7% → $886/month.

4. Apply the Rule of 72 for quick doubling estimates: Years to double = 72 ÷ annual return %. At 6%: 72 ÷ 6 = 12 years to double. At 8%: 72 ÷ 8 = 9 years to double. At 10%: 72 ÷ 10 = 7.2 years to double.

5. Calculate the cost of delay: Start at 25 vs. 30, same $500/month at 7%: at 25 → $2.4M by 65; at 30 → $1.7M by 65. Cost of 5-year delay: $700,000 — not 5 × $6,000 ($30,000) in contributions, but $700,000 in forgone compounding.

6. Account for inflation (real return): Real return = nominal return − inflation. Use 7% nominal → 4–4.5% real (net of ~2.5% inflation). Future purchasing power: $1,000,000 nominal in 30 years = ~$475,000 in today's dollars.

7. Model fee impact: 1% fee drag on $500/month at 8% for 30 years: fee scenario (7%) → $566,765 vs. no-fee (8%) → $680,239. Cost of 1% annual fee: $113,474 — illustrating why low-cost index funds matter.

Rules

• Always use consistent compounding periods — monthly contributions need monthly rate (annual rate ÷ 12) and monthly periods.
• Use real (inflation-adjusted) returns for goal-setting; nominal returns for account value projections.
• The Rule of 72 is most accurate between 6–10% rates; at extremes (>20% or <3%) use the exact formula.
• Fees, taxes, and inflation each apply their own Rule of 72 in reverse — a 3% expense ratio doubles the cost of investing every 24 years.

Examples

How much to save to retire at 60 with $2M, starting at 30? 30 years at 7% return. PMT = $2,000,000 × (0.07/12) / [(1 + 0.07/12)^360 − 1] = $1,772/month. At 7% real: $1,772/month adjusted for inflation. Rule of 72 check: money doubles every 10.3 years (72÷7). From 30→60: three doublings. $1k today → $8k at 60. Need $2M ÷ 8 = $250k equivalent contribution base. Ballpark consistent.

Common Mistakes

• Using annual rate without adjusting for monthly compounding — Applying 7% annual rate directly to monthly contribution calculations overstates growth; use 7%/12 = 0.583% per month.
• Ignoring inflation — $1M in 30 years at 3% inflation is worth $412,000 today. Goal-setting without inflation adjustment produces false confidence.
• Treating projected returns as guaranteed — 7–8% historical average includes years of −40%. The calculation is a planning tool, not a promise; actual results will deviate.

Finance disclaimer: This skill encodes professional best practices for educational purposes. It is not financial advice. Consult a licensed financial advisor before making investment decisions.