There is little difference during the beginning between all frequencies, but over time they slowly start to diverge. The following is a graph showing just that, a $1,000 investment at various compounding frequencies earning 20% interest. The more frequently interest is compounded within a time period, the higher the interest will be earned on an original principal. This is because interest is also earned on interest. When the loan ends, the bank collects $121 from Derek instead of $120 if it were calculated using simple interest instead. This is added to what is owed after year 1: In Derek's case:ĭerek's interest charge at the end of year 2 is $11. For compounding interest, rather than the original amount, the principal + any interest accumulated since is used. However, the year ends, and in comes another period. This interest is added to the principal, and the sum becomes Derek's required repayment to the bank for that present time. For the first year, we calculate interest as usual. Compound InterestĬompounding interest requires more than one period, so let's go back to the example of Derek borrowing $100 from the bank for two years at a 10% interest rate. Even when people use the everyday word 'interest,' they are usually referring to interest that compounds. However, simple interest is very seldom used in the real world. When more complicated frequencies of applying interest are involved, such as monthly or daily, use the formula: interest = principal × interest rate × Interest = principal × interest rate × term The formula to calculate simple interest is: He would simply be charged the interest rate twice, once at the end of each year.ĭerek owes the bank $120 two years later, $100 for the principal and $20 as interest. Let's assume that Derek wanted to borrow $100 for two years instead of one, and the bank calculates interest annually. This interest is added to the principal, and the sum becomes Derek's required repayment to the bank one year later.ĭerek owes the bank $110 a year later, $100 for the principal and $10 as interest. Derek would like to borrow $100 (usually called the principal) from the bank for one year.
The following is a basic example of how interest works. There are two distinct methods of accumulating interest, categorized into simple interest or compound interest. The concept of interest is the backbone behind most financial instruments in the world. Interest is the compensation paid by the borrower to the lender for the use of money as a percent or an amount.
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