Compound Interest Explained

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Compound Interest Explained


Explaining Compound Interest

Compound interest is a concept that refers to the interest earned on both the initial amount of money you invest (known as the principal) and the accumulated interest from previous periods. In other words, instead of earning interest only on your original investment, compound interest allows your investment to grow by earning interest on the interest you've already earned.

To understand compound interest better, let's go through an example:

Let's say you invest $1,000 in a savings account with an annual interest rate of 5%. At the end of the first year, you will earn $50 in interest (5% of $1,000). So your total investment value after one year would be $1,050.

Now, instead of withdrawing the interest, let's assume you leave the money in the account to earn interest for another year. In the second year, the 5% interest will be calculated based on the new total of $1,050. This means you will earn $52.50 (5% of $1,050) in interest. Therefore, your total investment value at the end of the second year would be $1,102.50.

As you can see, in the second year, you earned $2.50 more in interest compared to the first year because you earned interest on the interest from the previous year. This compounding effect continues to accumulate over time, allowing your investment to grow at an increasing rate.

Here's a simple table to illustrate the growth of your investment over a few years:

Year Initial Investment Interest Earned Total Investment Value
1 $1,000 $50 $1,050
2 $1,050 $52.50 $1,102.50
3 $1,102.50 $55.13 $1,157.63
4 $1,157.63 $57.88 $1,215.51
5 $1,215.51 $60.78 $1,276.29

As you can see from the table, the interest earned each year increases as the investment grows. This compounding effect can be represented graphically, with the investment value increasing at an accelerating rate over time.

Compound interest can be a powerful tool for long-term investments because it allows your money to grow exponentially. The longer you leave your money invested, the greater the compounding effect, and the more significant your returns can be.

Remember that the actual returns will depend on various factors, such as the interest rate, the investment duration, and any additional contributions or withdrawals you make.

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