The Paper Source Virtual Note Symposium October 2020

What Is Compound Interest?

By James Redden | Published by The Calculator Site

Do you really understand what compound interest means and how it works? Most importantly: do you know how it can benefit you?

We all like the thought of earning interest on our savings and investments. Equally, we all hate having to pay interest on loans and debts. With some deft mathematical footwork it’s possible to cancel out the interest on your debts by using the compound interest that accumulates on your savings.

Let’s look at the basics of compound interest. Then we’ll look a little at the formula for compound interest. Once we’ve got through that, you’ll be ready to have a play around with some figures using the compound interest calculator.

What is compound interest?

Here’s an explanation that should make everything crystal clear:

When you take out a loan, interest is calculated for the first period (be it a month or a year). This interest is then added to the original total. Following on from that, the interest for the next period is calculated but is based on the gross figure from the first period. From there, well, you get the idea.

It does sound complicated. So, as it’s often said a picture paints a thousand words, here’s an illustration:

Example # 1

Let’s say you borrow $2,000 over a 3-year period, pay 10% annual interest on your debt and are not making regular repayments. In this case, the amount you will have to repay will look like this:

Year 1: $2,000 x 10% = $200.
Year 2: $2,200 x 10% = $220.
Year 3: $2,420 x 10% = $242.

The total repayment figure after 3 years is $2,662 (the $662 interest is the sum of each year’s interest).

It should be noted that if you make regular repayments on your loan, the total compound interest will be lower because the remaining principal on the loan will be decreasing at each compound interval. The Calculator Site has a loan calculator if you want to try out some figures.

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