What Is Compound Interest?

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Compound interest (also known as compounding interest) is the interest on a loan or deposit that is computed using both the initial principal and the interest accumulated over time. Compound interest, which is said to have originated in 17th-century Italy, is “interest on interest” and will cause a sum to grow at a quicker rate than simple interest, which is computed just on the principal amount.

Compound interest accrues at a rate determined by the frequency of compounding, with the higher the number of compounding periods, the higher the compound interest rate. Thus, during the same time period, the amount of compound interest accrued on $100 compounded at 10% annually will be less than that on $100 compounded at 5% semi-annually. Compounding is sometimes referred to as the “wonder of compound interest” since the interest-on-interest effect can yield more positive returns based on the starting principal amount.

How Compound Interest Works

Compound interest is computed by multiplying the initial principal amount by one and then multiplying the annual interest rate by the number of compound periods minus one. The loan’s total beginning amount is then deducted from the final value.

The following is the formula for computing compound interest:

  • Compound interest = total amount of principal and interest in future (or future value) less principal amount at present (or present value)

= [P (1 + i)n] – P

= P [(1 + i)n – 1]

Where:

P = principal

i = nominal annual interest rate in percentage terms

n = number of compounding periods

Take a three-year loan of $10,000 at an interest rate of 5% that compounds annually. What would be the amount of interest? In this case, it would be:

$10,000 [(1 + 0.05)3 – 1] = $10,000 [1.157625 – 1] = $1,576.25

Pros and Cons of Compounding

Compounding can operate against consumers who have loans with very high interest rates, such as credit card debt, despite the mythical account of Albert Einstein declaring it the eighth wonder of the world or man’s greatest invention. A $20,000 credit card load with a 20% compounded monthly interest rate would result in a total compound interest of $4,388 over a year, or about $365 per month.

Compounding, on the other hand, can work in your favour when it comes to investing and can be a powerful element in wealth building. Compounding interest’s exponential growth is especially significant in moderating wealth-eroding causes including rising costs of living, inflation, and decreasing purchasing power.

Mutual funds are one of the most straightforward ways for investors to gain from compound interest. Reinvesting dividends from a mutual fund leads in the purchase of more shares of the fund. Over time, compound interest accumulates, and the cycle of purchasing more shares will help the fund’s investment rise in value.

Consider a mutual fund with a $5,000 initial investment and a $2,400 annual contribution. The fund’s future worth is $798,500, based on a 12-percent average annual return over 30 years. The difference between the cash committed to an investment and the investment’s actual future worth is known as compound interest. Compound interest is $721,500 of the future sum in this scenario, based on a contribution of $77,000, or a cumulative contribution of merely $200 per month, over 30 years.

Unless the money is in a tax-sheltered account, compound interest earnings are taxable, and it’s usually taxed at the regular rate linked with the taxpayer’s tax bracket.

Who Benefits From Compound Interest?

Simply defined, compound interest is beneficial to investors, but the term “investors” has a wide definition. Banks, for example, benefit from compound interest when they lend money and then reinvest the interest into making more loans. When depositors receive interest on their bank accounts, bonds, or other investments, compound interest is also a benefit.

Although the term “compound interest” incorporates the word “interest,” it is crucial to stress that the concept extends beyond instances where the word “interest” is commonly used, such as bank accounts and loans.

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