What Is Compound Interest?

What Is Compound Interest?

By Charles Joseph | Editor, Financial Affairs
Reviewed by Corey Michael | Senior Financial Analyst

Compound interest is the interest calculated on the initial principal, which also includes all of the accumulated interest from previous periods of a deposit or loan. Thought to have originated in 17th century Italy, compound interest can be thought of as “interest on interest,” and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount.

Related Questions

1. How is compound interest calculated?

Compound interest is calculated by multiplying the initial principal amount by one plus the annual interest rate raised to the number of compound periods minus one. The formula for compound interest is A = P (1 + r/n)^(nt), where P = principal amount (the initial amount you borrow or deposit), r = annual interest rate (as a decimal), n = number of times that interest is compounded per year, t = the time the money is invested or borrowed for, in years.

2. Why is compound interest significant for investments?

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Compound interest is significant for investments because it allows your money to grow faster as interest is calculated on the accumulated earnings of past years, not just on the original amount invested. Over time, even a small investment can grow substantially due to the power of compounding.

3. What’s the difference between compound interest and simple interest?

The main difference between compound interest and simple interest is that compound interest includes interest on interest. It’s calculated on the principal amount and also on the interest that has previously been added. Simple interest, on the other hand, is calculated only on the initial amount (or ‘principal’) that was deposited or borrowed.

4. How does the frequency of compounding impact the total interest?

The frequency of compounding can have a significant impact on the total interest. The more frequently interest is compounded (i.e., the ‘n’ in the formula), the more interest will be earned on an investment or paid on a loan over time. This is because more compounding periods allow for additional interest to be earned on the previously accumulated interest.

5. Can compound interest work against me?

While compound interest can significantly increase the value of an investment, it can also work against you if you have loans or debts. Compound interest applies to these financial products as well, meaning that interest can accumulate and increase the amount you owe significantly if debts are not paid off in timely manner.