Watch-it-Wednesday: Compound Interest Explained
Compound interest is "[interest] calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. Compound interest can be thought of as “interest on interest,” and will make a deposit or loan grow at a faster rate than simple interest, which is interest calculated only on the principal amount. The rate at which compound interest accrues depends on the frequency of compounding; the higher the number of compounding periods, the greater the compound interest. Thus, the amount of compound interest accrued on $100 compounded at 10% annually will be lower than that on $100 compounded at 5% semi-annually over the same time period. Compound interest is also known as compounding." -Investopedia
The formula for calculating compound interest is:
Compound Interest = Total amount of Principal and Interest in future (or Future Value)less Principal amount at present (or Present Value)
= [P (1 + i)n] – P
= P [(1 + i)n – 1]
(Where P = Principal, i = nominal annual interest rate in percentage terms, and n = number of compounding periods.)
If the number of compounding periods is more than
once a year, "i" and "n" must be adjusted accordingly. The "i" must be divided by the number of compounding periods per year, and "n" is the number of compounding periods per year times the loan or deposit’s maturity period in
years.
Compound Interest is something you want when it comes to savings and deposits, especially retirement savings, as they’ll grow much more quickly. But it’s not so great when it comes to loans, since the amount of interest you owe will add up fast.
We've previously covered the differences between simple, compound, and unearned interest: read more.