Compound Interest Calculation Example

How does compound interest work?

Compound interest is a concept where the interest earned on an investment or loan is added to the principal amount, allowing the interest to also earn interest over time. This creates a snowball effect that can significantly increase the value of the investment or debt over time.

When you deposit money into a savings account, for example, the bank will pay you interest on your deposit. With compound interest, the bank adds the interest it pays you back into your account, so the next time interest is calculated, it's based on the original deposit plus the interest earned. Over time, this can lead to exponential growth in the value of your savings.

Similarly, when you borrow money with compound interest, the interest owed on the loan is added to the principal amount, causing the total debt to grow more rapidly than with simple interest.

Understanding compound interest is crucial for making informed decisions about saving, investing, and borrowing money. It allows you to see how your money can grow over time and the impact of interest rates and compounding frequency on your financial goals.