What are compound interests in finance and how does it work?
In: Economics
Let’s say I give you a bonus cookie based on how many cookies you have in your lunch bag. I see you have ten cookies, and that earns you a free bonus cookie.
Instead of eating the cookies, you save them all.
Because you saved all the bonus cookies, eventually you have twenty cookies in your lunch. Twenty cookies means now you get TWO bonus cookies!
And so on and so on.
Soon you have so many cookies saved up, your bonuses get huge.
That’s compound interest.
Compound interest is essentially interest on interest. Say you have a principle (starting) amount and you reach your first interest period, so you get a percentage added onto the starting amount and it is reinvested so when the next investment period rolls around you will take that new sum and add a percentage of that amount and so on.
An example: you invest $1000 at 10% per year for 2 years.
The equation for compound interest is:
A=P(1+(r/n))^nt
A = your total
P = principle or initial amount invested
r = interest rate % (in decimal)
n = number of times interest is compounded in a period
t = number of time periods
In the example I gave the equation would look like this:
A=1000(1+(.10/1))^(1×2)
A = $1210.00
Hopefully that helped. If you need more explanation I will be happy to try.
Compound interest is repeatedly calculating interest on the accumulated principal and interest.
Eg. If you borrowed $100 at 10% interest rate per period, then after 1 period you own $100 + 10% * $100 = $110. Then the amount owed after 2 periods is $110 + 10% * $110 = $121.
The most common alternative is simple interest which means calculating the interest based on just the principal. Using the same example: period 1, $100 + 10% * $100 = $110, after period 2, $110 + 10% * **$100** = $120.
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