What is compound interest?
Compound interest is a method of calculating interest in which interest is earned or charged on both the original principal and the interest accumulated over time. As interest is added to the balance, future interest can be calculated on a larger amount.
Unlike the basic simple interest model, compound interest allows previously earned or charged interest to become part of the amount used to calculate future interest. This can cause the balance to grow at an increasing rate over time.
Compound growth can be calculated using the following formula:
Final amount
The total amount after compound interest has been added to the original principal.
Principal
The original amount of money invested or borrowed.
Annual interest rate
The annual interest rate expressed as a decimal in the formula. For example, 5% = 0.05.
Compounding frequency
The number of times interest is compounded during one year.
Time
The length of time the money is invested or borrowed, expressed in years.
If you invest $1,000 at a 5% annual interest rate compounded once per year, you earn $50 during the first year and the balance becomes $1,050. During the second year, the 5% interest is calculated on $1,050 instead of the original $1,000, allowing the previously earned interest to generate additional interest.