What is compound interest?

Compound interest is the interest that is calculated on both the initial principal and the accumulated interest from previous periods. This means that, over time, interest is earned not only on the original amount invested or borrowed but also on the interest that has already accrued. As a result, the total amount grows at an accelerating rate, which can significantly increase the value of an investment or the total repayment amount on a loan in the long run.

For example, if you invest $1,000 at an annual interest rate of 5% compounded yearly, after the first year you would earn $50 in interest. In the following year, the interest calculation would be based on $1,050 (the original principal plus the interest earned), which means you'd earn $52.50 in the second year. This compounding effect continues, leading to exponential growth of the investment over time.

Understanding compound interest is crucial for making informed investment decisions, as it highlights the benefits of saving and investing over longer periods, where the effect of interest compounding can lead to substantial growth.