Understanding Compound Interest
With all of the financial terms in the world, it seems that few
are more confusing than compound interest. Perhaps it is the
name that leads people to misunderstand exactly how it is that
compound interest works, or maybe it's the formula that is used
to compute it.
Compound interest doesn't have to be confusing, however; the
information below should answer most if not all of your
questions concerning compound interest and how it can affect
you.
What Compound Interest Is
Compound interest is simply interest that is collected both on
the principal (the original amount) and the interest that has
already been applied to the principal. This means that each time
interest is applied to the amount (also known as being
compounded), the amount of interest compounded will be added to
the principal for the next time that the interest is compounded.
To put it more simply... compound interest means that every time
interest is applied, it is applied based upon the entire amount
instead of just the principal.
What Compound Interest Does
Since compound interest is applied to all of the money held
within the account being compounded, this means that as time
goes by more money will accumulate within the account because
each increase will subsequently increase the amount being paid.
This is most often the case in savings accounts and
interest-bearing chequeing accounts, as well as with the
interest due on many loans.
How Compound Interest is Calculated The formula for calculating
compound interest is written as A = P(1 + r) n , with A being
the amount of money accumulated after the interest is
compounded, P being the principal amount of deposit, r being the
annual rate of interest, and n being the number of years over
which interest is collected. If the interest is being compounded
more regularly than once per year, the r is divided by the
number of times that the interest is being compounded (for
monthly interest, this would be 12 times, and for daily interest
it would be 365 times.) As an example, imagine P being 100, on 5
percent interest (compounded monthly), over a period of 5 years.
This would look like A = 100(1 + 5/12) 5 , or 100 x (1 + 5/12),
with the portion in brackets multiplied by itself 5 times.
How Compound Interest Works for You Since compound interest pays
additional interest money based upon the interest that has
already been paid, this means that as time goes by you will be
making a significant amount of money simply from having your
principal deposit in your savings or other bank account. You
should be sure to keep in mind that many banks and other lenders
use compound interest on their loans as well, so that the longer
that you take to repay the loan then the more you will have to
repay. This can be an incentive to repay debts during a grace
period, or at least to do your best to pay off the debt as early
as possible so that you can save as much money as you can.
Finding the Best Compound Interest Rates
In order to find the best compound interest loan rates, it's
important to take the time to shop around and explore your
various options concerning the type of account or loan you're
looking for. Request rate quotes and compare them to each other
to ensure that you get not only a rate that you're satisfied
with but also the best rate that you can get.
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