What is Compound Interest?
First, lets start with the concept of “simple” interest. Simple interest refers to the calculation of interest based on the “principle” or initial value.
For example, if you have $10,000 and earn 10% interest, the simple interest calculation would be:
$10,000 x 0.10 = $1,000
Compound interest is the calculation of interest based on the principle AND accrued (i.e. accumulated, earned, etc.) interest. Let’s take the simple interest equation above and turn it into a compound interest example.
If you have $10,000 and earn 10% interest per year, how would you calculate the interest in the second year using compound interest?
Year 1 = $10,000 x 0.10 = $1,000
Year 2 = ($10,000 + $1,000) x 0.10 = $1,100
Compounding allows you to earn interest on your interest, so to speak.