Compound interest definition

Compound interest meaning

Compound interest is also called interest on interest. Because of the impact on the finances brought by this process, it is commonly said that the power of compound interest is making people rich. Meaning that the sooner a person starts to save the better, since the power of compound interest will have more time to increase a person’s wealth.

Compound interest explained

When money is lent, the borrower has an obligation to pay back the debt plus the agreed interest. The interest is calculated for the principal amount for each period. If for some reason the agreed payment is not paid, then the interest calculated for that period will be added to the principal amount. Hence, the interest in the new period will be calculated for the principal amount plus the interest from the previous period.

From an investment perspective, a simple example of compounding interest can be a bank term deposit. Depositing money in a one-year term deposit would mean that at the end of the year the saver will receive their principal amount plus any interest paid by the bank. If the same savers decide to make a new one-year deposit with all of the money, then the amount of the new deposit would be the sum of the principal amount and the interest. At the end of the second year, the bank will calculate interest on the principal amount increased by the interest paid for the first year.

What is compound interest?

Let’s say that a person invests $1000 in a one-year instrument with 10% interest. At the end of the first year, the wealth of this person has increased by 10%, and is $1100 ($1000 principal amount and $100 interest received). The money is reinvested for another year at 10% interest. At the end of the second year, the person will receive their principal amount of $1100 and $110 interest, or $1210 in total. So, at the end of year two, the statement would look like this: $1000 initial balance, $100 end of year one interest and $110 end of year two interest received. The extra $10 received at year two is added because of the interest from year one. These $10 are the extra interest earned as a result of compounding interest. Imagine the amount after 30 or 40 years. This is why some experts say that it is important to start investing when you are younger since it is easier to build wealth through the power of compounding interest.

Factors affecting the power of compound interest

At first glance, it looks like the compound interest doesn’t make any difference. But as time goes by the increase in wealth can be quite substantial. There are several factors which can affect the compounding interest. These are compounding frequency, total compounding period, and interest rate.

Compounding frequency refers to the length of the compounding period, which could be daily, weekly, monthly, yearly, etc. When the period is shorter, there is a higher compounding frequency. Thus, when other conditions are equal, investors should always decide to invest their money in an investment with more frequent compounding periods. A second important factor is the length of the investment period. The power of compounding interest would increase the wealth much more during an investment period of 30 years compared with an investment period of 15 years.