Compound Interest

Compound interest is the form of simple interest where interest is added to the principle. When this happens, the interest that is added to the principle also earns interest. This method of addition of interest to the principle is known as compounding. Compounding is a term totally opposite to discounting. The compounding of interest can be easily understood if you study a bank account. If you have a principle of $1000 deposited in the bank and interest rate is 20%, you will have $1200 in your account at the end of the year. This $1200 will then become the principle for the next year, and you will be able to earn 20% on your new principle. This amount of interest of $1440 you have earned in the second year is the compounding of interest.

Since the use of the simple interest is rare, the compounding interest is generally used for finance and other related disciplines. Although, certain financial estimates make use of simple interest, it is not generally used. As most people usually think of these interest rates as yearly percentages, usually governments require the financial institution of their country to disclose the compound interest rates on deposits or advances clearly. This yearly rate of interest is usually referred to as effective rate interest, annual percentage rate (APR), annual equivalent rate (AER), and by many other terms. The above-mentioned government requirements help the consumers to compare the actual cost of borrowing in an easier manner.

Since the effect of compounding of the interest depends on the frequency with which the interest is compounded and the applied periodic interest rates, the frequency of the compounding and interest rates must be specified to define the real amount that is to be paid with interest under a legal contract. The conventions may differ from country to country but following are the common usages:

Periodic rate

The interest that is charged and subsequently compounded for each period is divided by the amount of principle.

Effective annual rate

This is the accumulated total interest divided by the principle. This is the interest that would be payable at the end of one year.

In finance and accounting, usually the periodic rate is quoted.