Compound interest is the interest calculated on the initial principal, which also includes all of the accumulated interest from previous periods on a deposit or loan. It is essentially "interest on interest." This concept is a powerful engine for wealth growth over time, making it a cornerstone of smart investing and long-term financial planning.
How Compound Interest Works:
Imagine you invest $1,000 at an annual interest rate of 5% compounded annually. After the first year, you'll earn $50 in interest, bringing your total to $1,050. In the second year, you'll earn 5% on $1,050, which is $52.50, bringing your total to $1,102.50. Notice how the interest earned in the second year ($52.50) is more than the interest earned in the first year ($50). This acceleration is the magic of compounding.
The Formula for Compound Interest:
The future value (FV) of an investment with compound interest is calculated using the following formula:
FV = P (1 + r/n)^(nt)
Where:
FV = Future Value of the investment/loan, including interest
P = Principal investment amount (the initial deposit or loan amount)
r = Annual interest rate (as a decimal)
n = Number of times that interest is compounded per year
t = Number of years the money is invested or borrowed for
Key Factors Influencing Compound Interest:
Principal Amount: A larger initial investment will grow more significantly due to compounding.
Interest Rate: A higher interest rate leads to faster growth.
Time: The longer your money is invested, the more time compounding has to work its magic. This is often considered the most crucial factor for long-term wealth building.
Compounding Frequency: More frequent compounding (e.g., daily vs. annually) can lead to slightly higher returns, as interest starts earning interest sooner.
This calculator helps you visualize how these factors can impact the growth of your investments over time through the power of compound interest.