The ability to calculate interest is a vital part of understanding how well you are managing your finances. Not only is interest likely a major player in whatever debt you may owe, but it can also be a key factor in making your money grow.
Know what the entire amount drawing interest is. This is the principal. For this example, let's say the principal is $10,000.
Decide if you want to calculate simple interest or compound interest. Simple interest is a one-time charge. Compound interest builds on itself from one period to the next. It could be compounded yearly, monthly or even daily.
To calculate simple interest, take the interest rate and divide by 100. If your interest rate is 7 percent, this would turn it into .07. Now multiply that decimal by the amount of the principal (which is $10,000 in our example) to get the interest. In this case, it would be $700.
Calculating compound interest is more complicated. Suppose your 7 percent interest is compounded every year, and it is for an investment, not a debt. That means $10,000 turns into $10,700 after one year. The following year you would earn interest of .07 multiplied by $10,700, which equals $749. Now the total comes to $11,449.
If you need to calculate compound interest over more than just a few periods of time, it is easier to use a formula instead of repeating a calculation over and over. To do this, first add a 1 to your interest rate decimal. Therefore a 7 percent rate would become 1.07.
Then convert this number to the power of your number of times the interest is compounded. If it is once a year for 12 years, then it would be 1.07 to the 12th power, which equals 2.25. That means your money will have grown 2.25 times at the end of 12 years.
Try to keep the interest you pay to a minimum. Your money will grow faster if you pay little to nothing in interest compared to what you receive in interest or appreciation of investments. This means paying off debts before you worry about investing, because your creditors are likely going to charge a higher interest rate than the interest rate any investment will pay out (with the possible exception of low-interest mortgages and student loans). When you have debt, it really is better to give than receive.
Keep in mind that when interest is compounded, it is often broken up into smaller amounts. For example, a 12 percent annual rate that is compounded monthly would result in 1 percent being compounded 12 times, which makes for 12.68 percent interest over a year. You can see for yourself if you follow the formula.