Compound Interest
We are usually familiar with the term \(\text {Compound interest}\), if not scroll down and see!
Contents
Definition
"Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it." - Albert Einstein
Compound interest is the basically the interest which is imposed on another interest. For example, if I take a loan of \($1000\)compounded annually such that the rate of interest is \(10%\), then my interest for the first year would be \(10%\) of \($1000\) that is \($100\). Then principal for the second year would be \(1000+100=$1100\). Then, the interest for the second year would be \(10%\) of \($1100\) that is \($110\).
So, we see that compound interest is the interest imposed on another interest.
Basic examples
To calculate problems on compound interest, we need to be familiar of the term Simple interest.
Compound vs. Simple
To better understand the difference, view the table below comparing the advantages and disadvantages of compound and simple interest.
| Principal | $10,000 |
| Rate | 5% (0.05) |
| Time (years) | 4 |
| Simple | $2,000 |
| Compound | $2,155.06 |
Not too large a difference yet. Let's give it time.
| Principal | $10,000 |
| Rate | 5% (0.05) |
| Time (years) | 20 |
| Simple | $10,000 |
| Compound | $16,532.98 |
Compound interest has essentially tripled (x2.65) your investment (principal). However, imagine that you loaned through compound. Certainly not something that happens. There isn't a "better" kind of interest. Simple and compound both have advantages and disadvantages. However, Albert Einstein certainly had an opinion on the matter.