how does compound interest work.
In: Economics
Compound interest means that the interest is added to the balance, and next period’s interest is calculated off of the total balance, including the interest. Hence, it compounds.
$100 gaining 10% interest, compounding annually, grows like this:
End of year 1 – 10% of $100 which is $10, total balance is $110.
End of year 2 – 10% of $110 which is $11, total balance is $121.
End of year 3 – 10% of $121 which is $12.12, total balance is $133.12.
End of year 4 – 10% of $133.12 which is $13.31, total balance is $146.43
You see how each year the amount of interest goes up? It’s compounding – you’re getting interest on the interest.
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