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Compound interest is the act of adding accumulated interest back to a loan's principal. When interest is added back to a loan, it then begins earning interest as well.
Compound interest is favorable from an investment standpoint, as an investor will earn interest not only on principal but also on interest that has been added to the principal. Compound interest is not favorable as a borrower.
Compound interest may also be known as APR (annual percentage rate), APY (annual percentage yield) or Effective Interest Rate. -
The formula for compound interest is: A=P(t+r)n.
P = "Principal" (the amount borrowed or financed)
t = Length of loan (number of years)
r = Annual interest rate (percent)
n = Number of times interest is compounded annually
A = Amount of money accumulated after "n" years
If a loan is made for five years, the formula would change to look like this: A=P(1+r)5.
Interest may be compounded annually, quarterly or monthly. The above formula may be applied to money invested or borrowed. -
If $1,000 is borrowed for one year at an interest rate of 5 percent, how much money would be owed at the end of one year? Just plug the numbers into the equation:
P=$1,000
t = 1
r = .05 (5 percent in decimal form)
n = 1
A=1,000(1+.05)1, so A=$1,050
