Compound interest is a concept in interest calculation that involves earning interest not only on the initial amount of money or principal but also on any previously accumulated interest.
This means that as time goes on, the interest earned on an investment or loan can increase exponentially. Compound interest is typically calculated and added to the principal at regular intervals, such as annually, quarterly, or monthly, depending on the terms of the investment or loan. This compounding effect can result in significant growth of funds over time, making compound interest a favourable feature for investors and a factor to consider when making financial decisions. The interest can be compounded daily, monthly, quarterly, semi-annually, or annually.
The main advantage of compound interest is that it allows an investment’s value to grow faster than if the interest were not reinvested. When interest is reinvested, the interest earned in each subsequent period is added to the principal so that the principal grows at an accelerating rate.
How compound interest is different from simple interest?
Compound interest differs from simple interest in the way the interest is calculated and added to the principal amount. With simple interest, interest is only earned on the initial principal amount and does not accumulate on any previously earned interest. In contrast, compound interest involves earning interest not only on the initial principal but also on any previously accumulated interest. This compounding effect can result in higher overall interest earnings compared to simple interest over a given period.
Is Compound Interest Always Good?
Compound interest can work for or against an investor. It works for an investor when the interest earned is reinvested and grows faster than the inflation rate. In this case, the purchasing power of the investment increases over time. Compound interest works against an investor when the interest earned is not reinvested, and the inflation rate is greater than the rate of return on the investment. In this case, the purchasing power of the investment decreases over time.
Assuming that all else is equal, the higher the compound interest rate, the faster the value of an investment will grow. The frequency of compounding also affects the growth rate of an investment. The more often interest is compounded, the faster the value of the investment will grow.
To calculate compound interest, one must first determine the principal, the interest rate, and the number of compounding periods. The principal is the initial amount of money invested. The interest rate is the percentage of the principal paid as interest. The number of compounding periods is the number of times per year that interest is compounded.