How to Calculate Annual Compound Interest

Video Transcript

"Hello, my name is Mark Griffith, and this is a very short explanation of how to calculate compound interest. Most people understand simple interest, which is percentage of a total amount. And if I borrow one hundred pounds at a simple interest rate of five percent, that means I am paying five percent each year in order to borrow the money. All that compound interest means is that you add back the extra debt to the total amount, so that if a year has gone by, for example, and I have not paid the interest rate, then we could say that I owe one hundred and five pounds, and then you're calculating five percent not of one hundred pounds, but of one hundred and five pounds. And that's going to be--five percent of a hundred pounds is five pounds, and five percent of five pounds is going to be twenty-five new pence, so it actually means that the amount of interest that you owe gradually goes up at a slightly accelerating rate, because you are paying back money, not simply on the principal--the original that you borrowed--but you're paying back on the interest that you haven't paid. This is how credit card companies make money. Because if you delay paying back your credit card bill for the end of the month, you're paying interest on the principal, and you're paying interest on the interest. And, of course, if you carry on for long enough, you're paying interest on the interest on the interest. So, compound interest is what people in the Middle Ages used to call usury, and it can be bad news if you owe money, so pay attention to it, and work out how it works. It's the difference between just paying a fixed sum each year, or each month, and paying a fixed sum on top of the extra money that you owe. Be careful."