Have you ever asked yourself this question: how does compound interest work? The truth is, it's quite simple to understand.
To understand compound interest, we first need to grasp how interest works.
Interest is the price paid for the use of a borrowed sum of money.
Compound interest is interest that is added to the initial principal, and new interest is then generated on that combined amount. In this case, money has a multiplying effect because interest generates new interest. In contrast, with simple interest, returns are always calculated on the original principal.
In short, compound interest is a way of accumulating interest over time.
- How do we calculate this type of interest?
To calculate this type of interest, you need to know the following: multiply the initial amount by the interest rate percentage by the number of payment periods.
With this in mind, calculating compound interest becomes simpler — it is calculated on the balance of an account plus any accumulated interest. That is, if you deposit $200 into your account and have a 5% interest rate, you simply multiply 200 by 0.05, giving you a result of $10. That would be your earnings from compound interest, leaving you with $210 in your account.