What is Compound interest?
Compound interest is called "interest on interest" because it grows both the initial principal amount and the accumulated interest from earlier periods. This means the interest you earn grows over time, accelerating the growth of your investment.
Compound interest is typically calculated at regular intervals, such as annually, semi-annually, quarterly, or even monthly. The more frequently interest is compounded, the faster your money grows. This is because you're earning interest on a larger principal amount more often.
Banks and other financial institutions use compound interest to calculate the growth of savings accounts, investments, and even loans. Compound interest is a powerful tool that, if used effectively, can help you achieve your financial goals.
Formula of Compound Interest
Compound interest is the interest accrued on the original principal sum as well as the interest accumulated from prior periods. This "interest on interest" effect accelerates your investment growth over time.
To calculate the compound interest (CI), we use the formula:
CI = P (1 + r/n)^nt - P
where:
CI: Compound interest
P: Principal amount (initial investment)
r: Interest rate (as a decimal)
n: Number of times interest is compounded per year (compounding frequency)
t: Time period (in years)
Simplifying for Annual Compounding:
When interest is compounded annually, meaning interest is applied only once a year, then n = 1. In this case, the formula simplifies to:
A = P (1 + r)^t (to calculate the compound amount, A)
CI = P (1 + r)^t - P (to calculate the compound interest, CI)
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