Compound interest (CI) is the interest that is earned on the initial principal and also on the accumulated interest of previous periods.
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.
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 at a rate greater 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 rate of inflation 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 that is paid as interest. The number of compounding periods is the number of times per year that interest is compounded.