Compound Interest isn't really a miracle, although sometime it can see like that! Last week we discussed simple interest, where the interest is calculated and paid at the end of the time period. This week we will step it up a notch and talk about compounding interest. Compounding is the addition of the interest to the principle before the next interest payment is calculated. This means that the accumulated interest payments in addition to the principle will receive interest for the next payment. This leads to an exponential growth of the loan or deposit. This is the most common type of interest currently used in commercial settings. If you have a savings bank account it will almost certainly be compounded daily for a monthly interest payment.
Frequency of the payments is important for compounding interest. For example; a 5% deposit compounded annually will receive less interest than a 2.5% deposit compounded every 6 months.
To calculate compound interest, use the following formula:
I = P [(1 + r)n – 1]
Where:
I= Interest on loan or deposit
P = Principle of loan
R = Rate of Interest per time period
n = number of time periods
P.S. Make sure your Interest rate and time periods are the same duration. Often you may find them quoted in different durations.
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