Compound interest is the interest on a loan or deposit that is calculated based on both the initial principal and the accumulated interest from previous periods. In other words, compound interest is “interest on interest.”
It differs from simple interest, where interest is calculated only on the initial amount (principal) that was deposited or borrowed.
Here’s how compound interest works:
Let’s say you have $1,000 in a savings account that earns an annual interest rate of 5%, compounded yearly.
After the first year, you would earn $50 in interest (5% of $1,000). This brings your total balance to $1,050.
In the second year, you earn interest not just on your initial $1,000, but also on the $50 in interest that you earned in the first year. So, your interest for the second year would be $52.50 (5% of $1,050), and your total balance would be $1,102.50.
In the third year, you would earn interest on $1,102.50, and so on. Over time, this compounding effect can significantly increase the amount of money you earn from interest, especially if the interest is compounded more frequently (for example, monthly or quarterly, instead of yearly).
It’s important to understand the concept of compound interest because it’s a fundamental principle in finance that impacts various aspects of personal finance, including loans, mortgages, savings, and investments.
#finance #interest #interestrate #loans #compoundinterest
