How is compound interest calculated?

Compound interest is calculated on both the initial principal and the accumulated interest from previous periods. This means that as interest is added to the principal, the base on which future interest is calculated grows, leading to a compounding effect. Each interest period increases the total amount on which the next interest is calculated, leading to exponential growth over time.

For instance, if you invest $1,000 at a 5% annual interest rate, after the first year, you will earn $50 in interest. In the second year, interest is calculated on the new total of $1,050, resulting in $52.50 of interest for that year. This cycle continues, and with each compounding period, you earn interest on both the original amount and the interest that has already been added. This results in a significantly higher return compared to simple interest, which is calculated only on the original principal.

Understanding how compound interest works is crucial for making informed financial decisions regarding savings, investments, and loans, as it greatly influences the overall growth of financial assets over time.