What is Compound Interest?
Compound Interest, sometimes called "compounding interest", is when interest is added to the principal amount after each period. The next recurring interest calculation then includes the principal along with the accumulated interest. Because of this, compound interest is often referred to as "interest on interest". This is opposed to simple interest, which only calculates interest using the principal. In the end, compound interest can potentially grow a sum exponentially.
The rate at which compound interest is accumulated is based on the compounding frequency. The more compounding periods there are, the higher the compound interest. Conversely, less compounding periods means less compound interest. That means that $1000 compounded at 10% per year will accrue much less compound interest than $1000 compounded at 5% per year.
What is the Formula for Compound Interest?
The formula to calculate compound interest is as follows:
Compound Interest = Total Future Value amount of Principal and Interest less the present Principal amount.
= [P (1 + i)n] – P
= P [(1 + i)n – 1]
In these equations, P = Principal, i = nominal annual interest rate (as a percent), and n = number of compounding periods. It is important to remember that if the number of compounding periods is more than once per year, then the values of "i" and "n" must be adjusted in the appropriate manner. The "i" value should be divided by the number of compounding periods per year. In addition, the value "n" represents the number of compounding periods per year multiplied by the loan's maturity period (in years).
Remember that growth is the central purpose of compound interest. So as each compound period ends, the interest from that period is now integrated into the principal amount. This then increases the interest calculation on the next period, and so on, and so forth until the loan is paid in full.