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What Is Compound Interest?

what is compound interest

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  • If the money has not been withdrawn/ paid, the interest will increase over a period of time.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.