how does compound interest work.
In: Economics
Its really pretty simple. You have a certain amount of money – known as the princple – and interest is calculated at a fixed rate over a fixed period of time (known as the compounding period). The interest payment is then added to the original principle, and this higher amount becomes the _new_ principle for future calculations.
So, in an example. I have $100 in principle that earns 10% interest every month, and it compounds monthly.
In month 0, I have $100 (my original deposit)
At the end of month 1, I get $10 in interest ($100 * 10%) and its added to my original $100, so now I have $110
At the end of month 2, I get $11 in interest ($110 * 10%) and its added to my previous $110, so now I have $121
At the end of month 3, I get $12.10 in interest ($121 * 10%) and it is added to my previous $121, so now I have $133.10
Etc.
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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