Compound Interest – How Does Compound Interest Work?

What is Compound Interest?

Compound interest, otherwise known as (compounding interest) is a concept for managing your finances. It is a process of growing and is interest earned on money that was previously earned as interest.

Compound Interest - How Does Compound Interest Work?

How Does Compound Interest Work?

Compound interest accrues on the rate of frequency of compounding, such that the higher the number of compounding periods, the greater the compound interest. This implies, that the amount of compound interest that accrues on $100 compounded at 10% annually will be lower than that on $100 compounded at 5% semi-annually over the same period of time. Now since the interest-on-interest effect can generate increasingly positive returns depending on the initial principal amount, thus it has been referred to as sometimes as the ‘miracle of compound interest’.

Why is Compound Interests Powerful?

Time

When we say time, it means that compounding is more dramatic over long periods. Additionally, you’ve got a higher number of calculations. Or ‘credits’ to the account when money is left alone to grow.

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Starting Amount

Here, it means that the amount of money you start with does not affect compounding. Thus for whatever amount you start with. Compounding works the same way. Even though the earnings seem bigger when you start with a large deposit. You still don’t get penalized when you start small or keep accounts separate. Thus it is ideal to focus on percentages. And the time when planning for your future.

Deposits

Withdrawals and deposits also have a way of affecting your account balance. Allowing your money to grow or regularly adding new. Deposits to your account kind of works best. This means that, if you withdraw your earnings. You dampen the effect of compounding.

Frequency

Compounding more frequently like daily, have more dramatic effects. It is advised that when you are opening a savings account. You should look for accounts that compounds daily. You may only see interest payments added to your account monthly. Although you can still do calculations daily. Some accounts on the other hand. Only calculate interest monthly or annually.

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Interest Rate

In your account balance, the interest rate also plays a vital role over time. Higher rates imply an account will grow faster. Even though compound interest can overcome a higher rate. Mostly over long periods, an account with compounding but a lower rate can end up with a higher balance than an account with the aid of a simple calculation.

How to Calculate Compound Interest

You can simply calculate compounds’ interests by multiplying the initial principal amount by one plus the annual interest rate raised to the number of compounds periods minus one. Thereafter, the total initial amount of the loan is then subtracted from the resulting value.

Here is the formula:

Compound Interest = Total amount of Principal and Interest in future (or Future Value) less Principal amount at present (or Present Value)

= [P (1+i)n] – P

=P [(1 + i) n-1]

(Where P = Principal, i = nominal annual interest rate in percentage terms and N = number of compounding periods.)

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