Have you ever thought about what compound interest stands for? It’s clear that the term ‘compounding’ refers to the ‘interest on interest’. To be more precise, it stands for the process where the interest is credited to an existing principal amount and the interest already paid.
Everyone calls the interest on interest as the ‘miracle of compounding’. On the other hand, there is also compounding in forex, which stands for proper money management technique. It allows you to take the money you had made in profit to invest it in more weight.
So, what is precisely the compound interest, and why is it essential to know all about it?
The definition of compound interest – what you need to know
Compound interest stands for the interest on deposit or loan calculated both on the accumulated interest from the previous period and on the initial principal. It originates from the 17th century in Italy and is known as the ‘interest on interest’.
You may wonder what is so essential about it. The answer is that interest-on-interest will make the sum grow faster than is the case with simple interest, which can be calculated just with the principal amount.
The rate at which compound interest accrues
If you were wondering what is responsible for the rate accrues, you must be aware that it all depends on compounding frequency. Remember, the higher the number of compounding periods, the compound interest will be greater.
The amount of compounding interest accrued annually on $100, compounded at only 10%, will be significantly lower than if the same amount of money is exacerbated at % five semi-annually over the same period. It happens because compounding interest effects can generate positive returns that are based on the initial principal amount.
How can you calculate the amount of compounding interest?
Imagine that you want to calculate the amount of compounding interest, but you are still unsure how to do it exactly. You can calculate the amount of compounding interest by multiplying the initial principal amount by one plus the interest rate on the annual period, which is raised to all the compound periods minus one.
Thus, the total amount of the loan gets subtracted from the resulting value.
What is the formula of compound interest?
The formula of compound interest goes like this:
= [P (1 + i)n] – P
= P [(1 + i)n – 1]
Remember, the ‘P’ stands for ‘the principal’, ‘i’ is the ‘nominal annual interest rate’, while ‘n’ represents the ‘number of compounding periods’.For example, the formula looks like this:
$10,000 [(1 + 0.05) 3 – 1] = $10,000 [1.157625 – 1] = $1,576.25
It means that you took a three-year loan of $10,000, at the interest rate of 5%, which compounds on an annual basis, and that, as we’ve seen from the example above, the amount of interest would result in $1,576.25.
In conclusion, the compounding interest means the ‘interest on interest’. This interest you can calculate on the initial principal that includes accumulated interest from previous periods on loan or deposit.