What is Compound Interest?
When you deposit money in a bank, the bank pays you interest , a reward for letting them use your funds. There are two main ways interest can be calculated:
- Simple interest adds a fixed amount each period, calculated as a percentage of the original deposit only.
- Compound interest adds a percentage of the current balance each period , so your interest earns interest too.
This distinction might sound minor, but over long periods the difference is enormous due to exponential growth.
Example
Deposit \text{\}5000$ into two accounts, both offering 5% annual interest.
- Account A (simple interest): balance increases by \text{\}(0.05 \times 5000) = \text{$}250$ every year.
- Account B (compound interest): balance is multiplied by every year.
After 50 years:
Compound interest produces more than three times the balance of simple interest over the same period!
Compound Interest: Interest calculated on both the initial principal and the accumulated interest from previous periods. The balance grows by a fixed percentage of the current amount each compounding period.