Compounding interest

Definition

Compounding interest is the process where the value of an investment increases because the earnings on an investment, both capital gains and interest, earn additional returns over time. Essentially, it means earning interest on interest.

5 Must Know Facts For Your Next Test

1. Compounding can be calculated annually, semi-annually, quarterly, monthly, or even daily.
2. The formula for compound interest is A = P(1 + r/n)^(nt), where A is the amount of money accumulated after n years, including interest.
3. The more frequently compounding occurs within a given period, the greater the total amount of compound interest.
4. Compound interest significantly impacts long-term investments and savings due to exponential growth over time.
5. Understanding compound interest is crucial for comparing different financial products like savings accounts, loans, and investments.

Review Questions

• What happens to your investment when it is compounded more frequently?
• How does compound interest differ from simple interest?
• Why is understanding compound interest important for long-term financial planning?

Related terms

Simple Interest: Simple Interest is calculated on the principal amount only and does not include previously earned interest.

Present Value (PV): Present Value is the current value of a future sum of money or stream of cash flows given a specified rate of return.

Future Value (FV): Future Value is the value of an asset or cash at a specified date in the future based on an assumed rate of growth.