Compound Interest

Compound interest is a fundamental concept in the financial world. Unlike simple interest, which is calculated only on the principal amount, compound interest is calculated on the principal plus any interest that has been added to it over time. This leads to “interest on interest,” significantly increasing the amount of interest earned or paid over time.

Examples§

1. Savings Account

   • Suppose you deposit $1,000 into a savings account with an annual interest rate of 5%, compounded annually. After the first year, you will earn $50 in interest, for a total of $1,050. In the second year, you will earn 5% on $1,050, which is $52.50, bringing your total to $1,102.50.

2. Investment

   • If you invest $10,000 at an annual interest rate of 8%, compounded monthly, after 5 years (60 months), your investment will grow to approximately $14,693.28. This is calculated using the compound interest formula with monthly compounding.

Frequently Asked Questions§

Q1: What is the formula for calculating compound interest?

• A: The basic formula for compound interest is: $$A = P \left(1 + \frac{r}{n}\right)^{nt}$$ Where:
  • $A$ = the future value of the investment/loan, including interest
  • $P$ = the principal investment amount (initial deposit or loan)
  • $r$ = the annual interest rate (decimal)
  • $n$ = the number of times that interest is compounded per year
  • $t$ = the number of years the money is invested or borrowed for

Q2: How does compound interest benefit long-term investments?

• A: Compound interest benefits long-term investments by increasing the amount of interest earned exponentially over time, as interest is calculated on the accumulated interest from previous periods.

Q3: Can compound interest be a disadvantage?

• A: Yes, compound interest can be a disadvantage for borrowers, as it can significantly increase the total amount to be repaid, especially for long-term loans.

Q4: What is the difference between compound and simple interest?

• A: Simple interest is calculated only on the principal amount, whereas compound interest is calculated on the principal amount and the accumulated interest from prior periods.

Q5: How often can interest be compounded?

• A: Interest can be compounded on various frequencies, such as annually, semi-annually, quarterly, monthly, daily, or even continuously.

Related Terms with Definitions§

• Interest: The cost of borrowing money, usually expressed as an annual percentage of the principal.
• Principal: The initial amount of money borrowed or invested, before interest.
• Annual Percentage Rate (APR): The annual rate charged for borrowing or earned through an investment, which does not account for compound interest within the year.
• Effective Annual Rate (EAR): The interest rate on an investment or loan that is compounded annually.

Online References§

• Investopedia: Compound Interest
• Khan Academy: Compound Interest

Suggested Books for Further Studies§

• “The Compound Effect” by Darren Hardy
• “Compound Interest & Time Value of Money: The Foundation of Investing” by Robert C. Appleby
• “Financial Planning & Analysis and Performance Management” by Jack Alexander

Accounting Basics: “Compound Interest” Fundamentals Quiz§

Thank you for exploring the intricacies of compound interest and testing your knowledge with our quiz. Keep delving deeper into the world of finance and investing!