Compound interest is the interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods. It can be thought of as “interest on interest”. The more frequently the interest is compounded, the greater the amount of compound interest earned.
Here is a step-by-step example of how compound interest works:
You invest $1000 at a 5% annual interest rate. At the end of the first year, the interest earned is: $1000 x 0.05 = $50. The total amount in the account after one year is: $1000 + $50 = $1050.
At the start of the second year, the interest is calculated on the new total amount of $1050. The interest earned in the second year is: $1050 x 0.05 = $52.50. The total amount in the account after two years is: $1050 + $52.50 = $1102.50.
This process repeats for the remaining years, with the interest being calculated on the new total amount each year. After five years, the final amount in the account would be $1276.28. So, you would earn $276.28 in interest over the 5-year period.
Compound interest is a very simple and safe way to save money over a long period. It can be used to calculate the future value of a savings account or the total cost of a loan. Compound interest can be a powerful tool for saving and investing, as the interest earned on the initial investment and the interest earned on the accumulated interest can add up quickly over time.