What is compound interest?

Compound interest is the process by which interest earned on an initial amount of money (the principal) is added back to that principal, so that in future periods, interest is calculated on the new, larger amount. This means you earn interest not only on your original investment but also on the accumulated interest from previous periods. It’s often described as "interest on interest," and it can significantly increase the growth of an investment or debt over time. In finance, compound interest works by reinvesting the interest you earn, which then becomes part of the principal for the next period’s interest calculation. For example, if you invest $1,000 at an annual compound interest rate of 5%, after one year you earn $50 in interest, making your new principal $1,050. The next year, you earn 5% interest on $1,050, which is $52.50, and so on. This compounding effect causes the investment to grow faster than with simple interest, where interest is only earned on the original principal. Compound interest is a fundamental concept in savings, loans, mortgages, and investments. The frequency of compounding (annually, semi-annually, quarterly, monthly, or daily) can impact how quickly the amount grows. The more frequent the compounding periods, the greater the total interest accrued. Understanding compound interest helps individuals and businesses make better financial decisions, whether they are saving, borrowing, or investing.