What Is Compound Interest?

By Andrew Stotz | August 6, 2020

Definition of Compound Interest

Compound interest is the interest on the initial principal as well as the interest from the prior periods.
It is also referred to as interest on interest.
With the same period of time, the sum of compound interest is always greater than simple interest because simple interest is the interest only on the initial value.
If the money has not been withdrawn/ paid, the interest will increase over a period of time.

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The three things that impact compound interest are interest rates, the length of time you leave the money in the investment, and the frequency of the compounding.
The higher the interest rate, the more you earn.
The longer you leave your money to compound, the more money you will end up having in the future.
The greater the number of times the money is compounded, the more you earn.
For example, if your money is compounded every day, you would make more than you would if it was compounded every month.

Compound interest can be calculated by taking the total principal amount and interest rate in the future minus the present value.

Compound Interest = [P (1 + i)^n] – P

Compound Interest = P [(1 + i)^n – 1]

(Where P = principal, i = nominal annual interest rate in percentage terms, and n = number of compounding periods.)

Using compound interest could be beneficial for depositors, investors, and lenders. But for borrowers, they would have to pay back more interest.
For example, an initial principal is $100, 10% compound interest rate annually.
- Year 1: $100 x 0.1 = $10
- Year 2: $110 x 0.1 = $21
We can also use the formula:
- Year 10: P [(1 + i)^(n – 1)]
- $100[(1 + 0.1)^(10 – 1)] = $159.3745
Note: It can only be used when there is no withdrawal/ payments made.

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