Compound Interest | What is Compound Interest | Example Of Compound Interest

What Is Compound Interest?

Compound interest is a type of interest that is calculated not only on the initial principal amount but also on the accumulated interest over time. This means that the interest earned in each period is added to the principal amount, and the interest for the next period is calculated on the new balance.

For example, let's say you deposit $1,000 in a savings account that pays 5% interest per year. At the end of the first year, you would earn $50 in interest, bringing the total balance to $1,050. In the second year, the interest is calculated on the new balance of $1,050, which means you would earn $52.50 in interest. By the end of the second year, your total balance would be $1,102.50.

As you can see, the interest earned in each year is added to the principal amount, which increases the balance and leads to even more interest earned in subsequent periods. This compounding effect can be very powerful over long periods of time and can lead to significant growth in your savings or investments.

Compound interest can be calculated on different time frames, such as daily, monthly, quarterly, or annually. The more frequently the interest is compounded, the faster the balance will grow. However, it's important to note that compound interest can work against you if you are borrowing money, as the interest can quickly accumulate and lead to a much larger debt over time.

What is the Formula of Compound Interest

The formula for compound interest can be expressed as:

A = P(1 + r/n)^(nt)

Where:

A is the total amount of money at the end of the time period

P is the principal amount (the initial amount of money invested or borrowed)

r is the annual interest rate (as a decimal)

n is the number of times the interest is compounded per year

t is the time period, in years

The formula calculates the future value of an investment or loan, assuming that the interest is compounded at regular intervals. The formula takes into account both the principal amount and the accumulated interest over time.

Example of Compound Interest

Below are few more examples of compound interest:

1. Suppose you invest $1,000 in a bond that pays 6% interest per year, compounded annually. After one year, you would earn $60 in interest, bringing your balance to $1,060. In the second year, you would earn $63.60 in interest ($1,060 x 6%), bringing your balance to $1,123.60. Over time, the interest earned on your investment would continue to compound, leading to significant growth in your balance.
2. Let's say you take out a loan for $10,000 with an interest rate of 4% per year, compounded monthly. Your monthly payment is $200. At the end of the first month, you would owe $9,947.78 ($10,000 + $33.33 in interest - $200 payment). In the second month, the interest is calculated on the new balance of $9,947.78, which means you would owe $9,895.41 at the end of the month ($9,947.78 + $32.94 in interest - $200 payment). The interest continues to compound each month, and your balance gradually decreases over time as you make payments.
3. Suppose you open a savings account with $500 and an interest rate of 3% per year, compounded daily. Over the course of a year, you would earn approximately $15.68 in interest, assuming no additional deposits or withdrawals. However, if you continue to make regular deposits and allow the interest to compound over a longer period of time, your balance could grow significantly. For example, if you make a $50 deposit every month for 10 years, your balance would grow to over $7,500 with compound interest.

Hope you understood Compound Interest, we have also provided you few examples of Compound Interest. How to calculate Compound Interest and formula of Compound Interest.