Compound interest

What is compound interest?

Compound interest is a method of calculating interest whereby interest earned over time is added to the principal. As with interest generally, compound interest is the key incentive for banks to issue loans and for depositors to keep money at banks. It is applied regularly to savings accounts or loans according to various compounding methods.

Deeper definition

There are two ways of thinking about interest: it is the price borrowers pay lenders for credit, or the fee depositors demand for leaving their money in a bank. In addition, there are two methods for calculating interest. With the simple-interest approach, interest is only calculated against the principal.

Compound interest is more subtle: interest is earned on the principle and previous interest payments — that is, interest accumulating on interest. Compound interest accrues over a compounding period specified in the terms and conditions of the account or loan. The compounding period is usually a year: at that point, regular interest is added to the principal, and interest begins accumulating against the combined amount.

For a savings account, that means earnings on an investment are retained so that the value of the investment increases every time the bank pays interest; for a loan, that means a percentage of interest that accrues during the compounding period is based on interest already owed and will end up costing the borrower more money, albeit not too much more. The process a bank uses to determine how interest compounds is called the compounding method.

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Compound interest example

DeAndre invests $100 at an interest rate of 5 percent. After the first year, his account is worth $105. After that period ends, the interest compounds, and the next year he earns 5 percent of $105, or $5.25, which brings his account to $110.25. As time goes on, the value of his investment increases. However, the third year, when his account is worth $115.76, DeAndre decides to withdraw the interest bringing his account down to $100. The following year, he only earns $5 again.

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