What Is Compound Interest?
Simply put, compound interest is the interest that is earned on interest. When interest is put on a principal, it adds to the total sum of the principal. The next time interest is put on the value, it is including the principal as well as the previously earned interest, which becomes compound interest. This is different from simple interest, where the interest is cannot compound since it is not included in the principal.
A compound interest rate relies not only on the rate percentage, but also the frequency of compounding. When calculated, it can give the yearly rate of compound interest, also known as the annual percentage rate or effective interest rate. Not only does compound interest applies to certain savings, such as the balance in a bank account, but it can also be used on a loan.
In legal contracts involving compound interest, the compounding frequency must be disclosed. The rate can be annually, semiannually, quarterly, monthly, or even daily. The periodic rate is one way to look at the effect of compound interest.
This is the interest that is charged for the period and then divided by the principal. As mentioned, the effective annual rate is another effective way to look at the rate of compound interest in order to see the total accumulated interest of a year divided by the principal value.
Effective annual rates are a more useful way to measure and compare compound interests because they help normalize the different uses of compound interest rates and allow for easy comparison
In order to calculate compound interest, a simple equation can be used. The total amount accumulated is equal to the 1 + the percentage of the annual rate of interest, all raised to the power of the amount of years in question and then multiplied by the principal.
An easy way to estimate compound interest is through the Rule of 72.
Dividing the number 72 by the interest rate of return is a quick way to determine roughly how much time is required to double the amount of the investment. For example, if the expected rate of return is 8%, in 72 divided by 8, or 9 years the investment’s value will be doubled.
Many government agencies, such as the United States Securities & Exchange Commission also provide compound interest calculators online to easily calculate the interest that will be earned over a given time. All that is required is the principal amount, interest rate, compound frequency, and the number of years.