Compound interest

Definition

Compound interest is the interest calculated on the initial principal and also on the accumulated interest from previous periods. This means that the amount of interest earned grows exponentially over time, as interest is earned on both the principal and the interest that has been added to it. This concept is crucial when dealing with loans and notes payable, as it affects how much borrowers will eventually repay over time.

5 Must Know Facts For Your Next Test

1. Compound interest can significantly increase the total amount owed over time compared to simple interest, especially for long-term loans.
2. The frequency of compounding (e.g., annually, semi-annually, quarterly, or monthly) can greatly affect the total amount of interest accrued.
3. Many loans, such as mortgages and student loans, use compound interest to calculate payments, making it important for borrowers to understand how it works.
4. When making investments, compound interest can work in favor of investors by generating returns not just on the original investment but also on the accumulated returns.
5. In financial planning, understanding compound interest helps individuals make informed decisions about savings and debt management.

Review Questions

• How does compound interest differ from simple interest in terms of repayment on notes payable?
  • Compound interest differs from simple interest primarily in how it is calculated and accumulates over time. With simple interest, the amount owed is only based on the initial principal, leading to linear growth. In contrast, compound interest accumulates on both the principal and previously earned interest, resulting in exponential growth. This means that borrowers with compound interest on their notes payable will end up repaying significantly more than those with simple interest due to this accumulating effect.
• Discuss how the frequency of compounding impacts the total amount paid on a note payable over its life cycle.
  • The frequency of compounding directly affects the total amount paid on a note payable because more frequent compounding results in more periods for interest to accumulate. For example, if interest is compounded monthly instead of annually, borrowers will incur more interest charges over the life of the loan due to the additional compounding periods. This means that understanding compounding frequency is crucial for borrowers to accurately assess their repayment obligations and plan their finances accordingly.
• Evaluate the importance of understanding compound interest in personal financial management and its implications for both borrowing and investing.
  • Understanding compound interest is essential in personal financial management as it influences both borrowing costs and investment returns. For borrowers, recognizing how compound interest affects loan repayment can help them choose better financing options and strategies to minimize overall debt. For investors, knowing how compound interest works allows them to make informed decisions about saving strategies that maximize returns over time. Ultimately, a solid grasp of compound interest enables individuals to manage their finances effectively and work towards achieving their financial goals.

Related terms

Principal: The initial amount of money borrowed or invested, which serves as the base for calculating interest.

Interest Rate: The percentage charged on a loan or paid on an investment, usually expressed annually, that determines how much interest will be accrued.

Amortization:

The process of spreading out a loan into a series of fixed payments over time, which includes both principal and interest components.