What Is Compound Interest?
The interest on a loan or deposit calculated based on both the initial amount and previous interest payments from previous periods is known as compound interest (or compounding interest).
Compound interest, also known as “interest on interest,” works in the same way. However, it will make a sum grow faster than simple interest, which is only calculated on the principal amount.
Compound interest accrues at a greater rate the more frequently compounding occurs, which is why the more times you compound, the higher your compound interest will be.
Because the interest-on-interest effect may result in increasingly favorable returns due to the initial principal amount, compounding has been referred to as the “miracle of compound interest.”
Compound Interest Formula
Total amount of principal and interest in future – principal amount at present = Compound interest
Compound Interest Schedules
Interest may be compounded daily, weekly, monthly, quarterly, semi-annually, or yearly. Financial instruments are typically compounded using established compounding frequency schemes.
Daily compounding is the usual method for banks to compound savings accounts.
- Certificates of Deposit: For a CD, daily, monthly, or semiannually is the typical compounding frequency.
- Money Market Accounts: Money market rates are often compounded daily.
- Loans: Loans are compounded monthly.
The number of compounding periods has a significant impact when calculating compound interest. The basic rule is that the greater the number of compounding periods, the more compound interest.
Compounding Interest Pros and Cons
Compounding interest plays a critical role in reducing wealth-eroding elements such as rises in the cost of living, inflation, and decreased purchasing power.
Money earned from compound interest is taxable unless kept in a tax-deferred account such as an IRA or annuity; it’s generally taxed at the taxpayer’s normal rate in their tax bracket.
Furthermore, those with high-interest debt and low credit scores may find themselves unable to borrow money because of compounding.