Understanding Compound Interest

With all of the financial terms in the world, it seems that few are more confusing than compound interest. Perhaps it is the name that leads people to misunderstand exactly how it is that compound interest works, or maybe it’s the formula that is used to compute it. Compound interest doesn’t have to be confusing, however; the information below should answer most if not all of your questions concerning compound interest and how it can affect you.

What Is It?

Compound interest is simply interest that is collected both on the principal (the original amount) and the interest that has already been applied to the principal. This means that each time interest is applied to the amount (also known as being compounded), the amount of interest compounded will be added to the principal for the next time that the interest is compounded. To put it more simply, compound interest means that every time interest is applied, it is applied based upon the entire amount instead of just the principal.

What Does It Do?

Since compound interest is applied to all of the money held within the account being compounded, this means that as time goes by more money will accumulate within the account because each increase will subsequently increase the amount being paid. This is most often the case in savings accounts and interest-bearing chequeing accounts, as well as with the interest due on many loans.

How Is It Calculated?

The formula for calculating compound interest is written as A = P(1 + r) n, with A being the amount of money accumulated after the interest is compounded, P being the principal amount of deposit, r being the annual rate of interest, and n being the number of years over which interest is collected. If the interest is being compounded more regularly than once per year, the r is divided by the number of times that the interest is being compounded (for monthly interest, this would be 12 times, and for daily interest it would be 365 times.) As an example, imagine P being 100, on 5 percent interest (compounded monthly), over a period of 5 years. This would look like A = 100(1 + 5/12) 5, or 100 x (1 + 5/12), with the portion in brackets multiplied by itself 5 times.

How Does It Work For You?

Since compound interest pays additional interest money based upon the interest that has already been paid, this means that as time goes by you will be making a significant amount of money simply from having your principal deposit in your savings or other bank account. You should be sure to keep in mind that many banks and other lenders use compound interest on their loans as well, so that the longer that you take to repay the loan then the more you will have to repay. This can be an incentive to repay debts during a grace period, or at least to do your best to pay off the debt as early as possible so that you can save as much money as you can.

Finding the Best Rates

In order to find the best loan rates, it’s important to take the time to shop around and explore your various options concerning the type of account or loan you’re looking for. Request rate quotes and compare them to each other to ensure that you get not only a rate that you’re satisfied with but also the best rate that you can get.