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Understanding Compound Interest

Understanding Compound Interest

Do you understand what compound interest is and how it works? In this article let’s discuss what compound interest is all about.   

What is compound interest?

Compound interest is interest paid on the initial sum as well as the accumulated interest on money you have invested. It’s like putting interest on interest, or accumulating interest over the term.

As an example, you make a 5-year term deposit of $5,000 and you have an annual interest of 5%. Earning compounding interest will be like this:

  • 1st year: $5,000 X 5% = $250
  • 2nd year: $5,250 X 5% = $262
  • 3rd year: $5,512 X 5% = $276
  • 4th year: $5,788 X 5% = $289
  • 5th year: $6,077 X 5% = $305

Your total balance or amount will be $6,382 or $1,382 in interest after five years. 

How to calculate compound interest

You can work out your monthly, quarterly, and annual compound interest using this formula depending on the compounding frequency:

  • Monthly: Principal (1 + interest rate/12)12months
  • Quarterly: Principal (1 + interest rate/4)4months
  • Annually: Principal (1 + interest rate)years

As an example, let’s use the annual formula and the previous figures: $5,000 deposit over 5 years at 5% p.a. The formula will be translated to: $5,000 (1 + 5% )5

You can also use an online compound interest calculator for easier calculation. Compound interest frequency will depend on the financial institution. It can be compounded on a monthly, quarterly, or yearly basis. Some will even have fees and other charges. The more frequently interest compounds and the more time you have, the more it will grow.  

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