HOW DOES COMPOUND INTEREST WORK
Compound interest is the concept of earning interest on both the initial amount of money (principal) and any previously earned interest. It is different from simple interest, where interest is calculated only on the principal amount.
To understand how compound interest works, consider the following components:
1. Principal amount: This is the initial sum of money you have, or the amount you initially deposit or borrow.
2. Interest rate: This represents the percentage of interest that is applied to the principal amount.
3. Compounding period: This is the frequency at which interest is added to the principal. It is usually specified as annually, semi-annually, quarterly, monthly, or even daily.
The formula for calculating compound interest is:
A = P(1 + r/n)^(nt)
where:
- A is the final amount or total value after compound interest has been applied.
- P is the principal amount.
- r is the annual interest rate (expressed as a decimal).
- n is the number of compounding periods per year.
- t is the number of years.
Here's an example to illustrate compound interest:
Let's say you deposit $1,000 into a savings account with an annual interest rate of 5% compounded annually for 5 years.
Using the compound interest formula, the calculation would be:
A = 1000(1 + 0.05/1)^(1*5)
A = 1000(1 + 0.05)^5
A = 1000(1.05)^5
A ≈ 1276.28
After 5 years, your initial deposit of $1,000 would have grown to approximately $1,276.28.
The key benefit of compound interest is that as time goes on, the interest earned on previous interest payments accumulates, accelerating the growth of your investment or loan balance. It allows your money to grow faster compared to simple interest, especially when compounded more frequently.