What is Compound Interest

Compound interest is interest calculated using the principal balance of an investment or loan, as well as the interest accumulated over a certain period of time.

Interest can be defined as either the cost of borrowing money, often charged on a loan balance, or the rate repaid for money after making a deposit.

So, what is the power of compound interest and why is it considered one of the most important concepts in finance?

There are two common ways to calculate interest; simple interest and compound interest.

Simple interest is calculated using the initial principal or the original amount of a loan or investment.

Unlike simple interest, compound interest can build on your wealth, just like a snowball rolling down a hill while gathering more snow with each rotation, compound interest will ensure your money grows exponentially as the years pass. In other words, compound interest is the interest you earn on interest, thus regarded as “interest on interest.”

In the realm of personal finance, there are few concepts such as compound interest that are powerful yet often misunderstood. If utilized, compound interest can turn small and consistent savings into substantial wealth over time. 

For instance, if you have saved $100 in an account that earns 5% interest annually, you’ll have $105 at the end of the first year. Things start to get interesting at the end of the second year since you’ll have $110.25 in your account. Not only have you earned $5 interest on your initial deposit, but also earned $0.25 on the $5 in interest. Over a period of time, the 25 cents will add up to something even though it doesn’t sound like much as first. Imagine in 10 years you’ll have more than $150, even if you don’t add more money to the account. 

However, it is important to understand that the number of compounding periods makes a significant difference when calculating compound interest. For instance, the amount of interest accrued at 10% annually for every $100 of loan will be lower than the interest accrued at 5% semiannually. In other words, the higher the number of compounding periods, the greater the amount of compound interest.

Key Points About Compound Interest

• Advantage of Compound Interest: The biggest advantage of compound interest is it’s ability to supplement savings over time.
• Compounding Periods: The number of compounding periods makes a significant difference to calculating compounding interest.
• Compound Interest Formula:
  = [P (1 + i)n] – P
  = P [(1 + i)n – 1]
  Where: P = principal; i = annual interest rate

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