Compound interest is a financial concept that refers to the interest that is earned not only on the principal amount of an investment but also on the interest accrued over time. In other words, it is the interest that is calculated on both the initial amount of money invested and the accumulated interest on that principal. The interest earned from the initial investment is added to the principal amount and the interest for the next period is calculated on this new, higher amount.
Compound interest can be contrasted with simple interest,
which only earns interest on the principal amount invested. In compound interest, the interest earned in one period is added to the principal for the next period, leading to exponential growth in the value of the investment over time.
For example, suppose an individual invests $100 in a bank account with a 5% annual interest rate. In the first year, they would earn $5 in interest, bringing the total value of the investment to $105. In the second year, the interest earned would be calculated on the new total amount of $105, resulting in an interest payment of $5.25. The total value of the investment at the end of the second year would be $110.25, and this process continues for subsequent years.
Compound interest is an essential concept in finance and can have a significant impact on investments over the long term. It can be used to calculate the future value of an investment or the present value of a future stream of payments. It is also a factor to consider when borrowing money, as the compound interest on loans can accumulate quickly, resulting in significant debt if not managed carefully.
In summary, compound interest is a powerful tool that allows for exponential growth in the value of an investment over time, making it an essential concept in finance that is critical to understand for investors and borrowers alike.
