Compound interest is a type of interest where in the interest added to the principal amount also earns interest starting from the time when it is added to the principal amount.Payments or investments using compound interest are done in a periodical manner. The interest earned in the period will be added to the principal amount and both will earn interest in the next period. This manner is called compounding wherein accumulated interest from previous periods will also earn interest as it goes along the succeeding payments.
For example: if the initial principal amount is $1000 and some financial institution is paying 10% interest per year, then at the end of first year the interest earned will be $1000 * 10/100 = $100. Hence the total principal amount at the end of the year will be $1000 +$100 = $1100.
When dealing with Compound Interest, next year the interest amount will be calculated using $110 as initial principal amount. Hence the interest earned at the second year will be $1100 * 10/100 = $110 So, principal amount at the end of second year will be $1210.
The increase of the amount is not constant since the interests paid also earn interest. Most of the times, banks and loaning agencies apply this type of interest especially for long term transactions.
Simple interest and compound interest differs in many aspects. Here are some of their differences:
Similar to simple interest, the same common factors affect compound interest but there are some additional things that should be taken into account.
Note: The nominal rate of interestis the annual interest rate.