What Is Compound Interest? | Investopedia

Recent questions

• What is compound interest?

  Compound interest is a method of calculating interest where the interest earned over time is added to the principal amount, resulting in interest being calculated on both the initial investment and the accumulated interest. This means that the total amount of interest earned grows at a faster rate compared to simple interest, which is calculated only on the principal. For example, if you invest $10,000 at an interest rate of 5% compounded annually, the interest earned after three years would be significantly higher than if it were calculated using simple interest. This compounding effect can lead to substantial growth in investments over time, making it a powerful tool for building wealth.

• How does compound interest work?

  Compound interest works by applying interest to both the initial principal and the interest that has already been added to that principal. This means that each year, the interest amount increases because it is calculated on a larger base. For instance, if you deposit $10,000 at an annual interest rate of 5%, the first year you earn $500 in interest. In the second year, you earn interest not just on the original $10,000, but also on the $500 earned in the first year, leading to a total interest of $1,576.25 after three years. This process of earning "interest on interest" accelerates the growth of your investment, making it more advantageous over long periods compared to simple interest, which would yield a fixed amount based solely on the original principal.

• Why is compound interest important?

  Compound interest is important because it significantly enhances the growth potential of investments over time. It allows individuals to earn more on their savings and investments compared to simple interest, which can lead to greater financial security and wealth accumulation. The power of compounding means that even small amounts invested early can grow substantially due to the exponential nature of interest accumulation. This is particularly beneficial for long-term savings goals, such as retirement, where the effects of compounding can result in a much larger nest egg. Understanding and utilizing compound interest can help individuals make informed financial decisions and maximize their investment returns.

• What is the difference between simple and compound interest?

  The primary difference between simple and compound interest lies in how the interest is calculated. Simple interest is calculated only on the principal amount, meaning that the interest earned remains constant over time. In contrast, compound interest is calculated on the initial principal plus any interest that has been added, resulting in a growing interest amount each period. For example, with a $10,000 investment at a 5% interest rate, simple interest would yield $1,500 over three years, while compound interest would yield $1,576.25. This difference can have a significant impact on the total returns of an investment, especially over longer periods, making compound interest a more advantageous option for investors looking to maximize their earnings.

• How can I calculate compound interest?

  To calculate compound interest, you can use the formula A = P(1 + r/n)^(nt), where A is the amount of money accumulated after n years, including interest, P is the principal amount (the initial investment), r is the annual interest rate (decimal), n is the number of times that interest is compounded per year, and t is the number of years the money is invested or borrowed. For example, if you invest $10,000 at a 5% annual interest rate compounded annually for three years, you would substitute P with 10,000, r with 0.05, n with 1, and t with 3. This calculation would show you how much your investment will grow over time, illustrating the benefits of compound interest compared to simple interest calculations.