How do you calculate interest on $25,000?

Unpacking Compound Interest: A $25,000 Example

Understanding how interest accrues, especially compound interest, is crucial for anyone managing savings or investments. While simple interest calculates earnings only on the principal amount, compound interest adds earned interest back to the principal, leading to exponential growth over time. Let’s illustrate this with a concrete example: calculating the compound interest on a $25,000 investment.

Scenario: You invest $25,000 at an annual interest rate of 10% for two years. We’ll assume the interest compounds annually.

The Formula: The cornerstone of compound interest calculation is the following formula:

A = P (1 + r/n)^(nt)

Where:

• A = the future value of the investment/loan, including interest
• P = the principal investment amount (in our case, $25,000)
• r = the annual interest rate (decimal, so 10% becomes 0.10)
• n = the number of times that interest is compounded per year (annually in this example, so n=1)
• t = the number of years the money is invested or borrowed for (2 years in this case)

Calculation: Substituting our values into the formula:

A = 25000 (1 + 0.10/1)^(1*2)

A = 25000 (1 + 0.10)^2

A = 25000 (1.10)^2

A = 25000 (1.21)

A = 30250

Therefore, after two years, your investment will be worth $30,250.

Finding the Interest Earned: To determine the interest earned specifically, we simply subtract the principal from the final amount:

Interest = A – P

Interest = $30,250 – $25,000

Interest = $5,250

Important Note: The initial example provided in the prompt uses a simplified formula, omitting the ‘n’ (compounding frequency) element. This simplification only works accurately when interest is compounded annually. If interest were compounded semi-annually (twice a year), quarterly (four times a year), or more frequently, the more complete formula above is essential for accurate calculations. Using the simplified formula in those scenarios would result in an underestimation of the final amount. This complete formula offers greater flexibility and precision for various compounding scenarios.

This example highlights the power of compound interest. While the difference might seem small over a short period, the effect is significantly magnified over longer investment horizons. Understanding this concept is critical for making informed financial decisions.