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- If the money has not been withdrawn/ paid, the interest will increase over a period of time.
What Impacts Compound Interest?
- 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.
How To Calculate Compound Interest?
- 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.)
Compound Interest In Practice
- 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.