Additional Resources

  1. Introduction To Compound Interest [learn5.humboldt.edu]
  2. Cash Flows & Compound Interest [cset.sp.utoledo.edu]
  3. Mathematics Of Money: Compound Interest Analysis With Applications [home.ubalt.edu]

Definition

The addition of interest to the principal sum of a loan or deposit is called compounding. Compound interest is interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously-accumulated interest. Compound interest is standard in finance and economics.

Compound Interest

The definition of compound interest refers to the accumulated interest on the initial balance. In other terms, any investment that earns interest, which is added to the first balance and interest, is paid on the original principal plus the combined interest. Hence, at the end, the compound interest payments increase exponentially.

As per Einstein compound interest is “one of the most powerful forces in nature.” This holds true for compound interests as well as your returns add up quickly.

An example:

Compound interest basically means interest that increases with time. Let’s look at the example to further understand the concept in depth:

Jack has a $1000, 5 year CD that pays him an interest of 5%, annually compounded. In the first year, the CD pays $50 in interest, which is then added to the principal. In the second year, the interest is paid on $1050 (total balance after adding the first year interest amount to the principal amount) now; the second interest payment would be at $52.50 which increases the balance at a total amount of $1102.50.

Key characteristics of compound interest:

  • Interest is paid on interest
  • Maximize gains on saving and investments that give compound interest
  • You can increase the amount owed if you have high interest on loans with minimum payments.

How to compute a compound interest?

The equation to compute compound interest is:

P=C (1+r/n) nt

Where:

P: Is the future value

C: The initial (first) deposit made

r: Is the interest rate (e.g. 8% or 0.08)

n: Is the number of times per year the interest is compounded

t: Is the number of years invested

How compound interest matters in the financial markets?

In the financial markets, the word compound interest is often termed as the smartest way to increase your wealth while taking the least effort from investors. The magic lies when investors keep adding money to the savings account at regular intervals so that there is more money to add interest on.

Investors should also take into consideration that compounding does not only relate to the interest earned, but also how much is paid in savings. For example, Joe borrowed $1000 from bank ABC, the amount of interest he would pay would be in relation to the rate at which it is compounded.

Note: The more frequently 'compounding' would occur, the more an individual will get or pay.

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