Business, Legal & Accounting Glossary
When interest is applied to capital and accrued up until that particular date. For example, a £1,000 loan with 20% interest will have a balance of £1,200 after the first year, then £1,440 at the end of the second year.
n. payment of interest upon principal and previously accumulated interest, which increases the amount paid for money use above simple interest. Thus, it can increase more rapidly if compounded daily, monthly or quarterly. The genius physicist Albert Einstein called compound interest man’s “greatest invention.” Most lenders agree.
Compound interest is the payment of interest on both principal as well past accrued interest. The opposite of compound interest is simple interest. Without compound interest, a $100 savings account at 10% per year earns a flat $10 in interest each year.
After 10 years that non-compound interest savings account is worth $200. With compound interest, that same $100 savings account earns $10 in interest the first year, but earns increasing amounts of interest in each subsequent year. The reason is that with compound interest, interest is paid on the previous years’ interest. After 10 years our $100 savings account with compound interest is worth more than $259. Albert Einstein called compound interest the eighth wonder of the world.
Compound interest is an important concept for any investor to understand. It truly can work wonders for your long-term gains if you understand its fundamental operation. Compounding interest involves adding the interest earned to your initial investment so that the interest itself earns interest. You can calculate compound interest using an equation with four essential factors.
To calculate what your investment will be worth in the future with a certain rate of compound interest, you begin with its present value. This is expressed as “PV” in the equation. It’s also often referred to as the initial investment.
The rate of interest you will earn on your investment is the next factor you need to know to perform your calculation. This is termed “i” in the equation. Of course, in a real-world situation, this often varies significantly over time, which is what makes investment formulas so complex and the outcome uncertain.
If you are adding interest back to your initial investment in order for it also to earn interest, you need to know how often this is going to happen. This is known as the compounding period. In a real-world situation, this can be annually, monthly, or, occasionally, daily. In the equation, you need to know the number of these compounding periods, expressed as “N”.
The last factor needed for the equation is the final value or “FV”, which is the value of the investment after compounding at the rate “i” for the number of periods “N”. Thus the equation to calculate compound interest is expressed: PV x (1+i) ^N = FV
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This glossary post was last updated: 5th August, 2021 | 0 Views.