Compound interest is the interest calculated on both the initial principal and the accumulated interest from previous periods of a deposit or loan.
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Understanding compound interest
Compound interest differs from simple interest. Simple interest is calculated only on the principal amount. Compound interest applies to the principal and any interest that has already accrued. This means the total amount grows at a faster rate over time because the account holder earns interest on their interest.
The frequency of compounding affects the final amount. Compounding can occur daily, monthly, quarterly, or annually. More frequent compounding periods result in higher overall interest. Financial institutions across global markets use varying schedules depending on the specific product. Savings accounts often compound monthly, while certain government bonds compound annually.
The calculation requires the principal sum, the annual interest rate, the compounding frequency, and the time period. Time is a significant factor in how large the final sum becomes. An early start allows the interest to compound over more periods, leading to mathematical growth of the balance. Investors and borrowers factor this into their financial planning.
Example
Consider an Elephant who deposits 10,000 currency units into a bank account that pays a 5% annual interest rate, compounded annually. At the end of the first year, the account earns 500 in interest, bringing the total balance to 10,500. During the second year, the 5% interest rate is applied to the new balance of 10,500. This generates 525 in interest, making the total balance 11,025. In the third year, the interest is calculated on 11,025, resulting in 551.25 in interest and a total balance of 11,576.25. The interest earned increases each year because the principal base continues to expand.