Compound interest is when you get interest on your interest. It doesn’t matter if you are paying interest or earning interest, the concept is the same. Compound interest is the method widely used in business and personal finance.
Here is an example:
Let’s say you put $1,000 in the bank at an interest rate of 4%. At the end of the year you would have $1,040 (your original $1,000 principal plus your $40 interest). Now you start getting compound interest so at the end of the second year you would have $1,082. Notice how you got more interest the second year? That’s because you got interest on your first year’s interest as well as interest on your principal. The amount you get in interest gets larger every year as you get interest on your interest. At the end of 10 years you would have $1,480.24. Where did the extra $80.24 come from? That’s the interest on your interest.
What happens if your interest is added to your principal more frequently, let’s say every month? In this case, there would be more interest because you would start getting compound interest at the end of each month instead of at the end of the year. The compound interest would grow faster.
What happens if the interest is added (compounded) every day? The interest would grow faster yet. That’s why it’s important to find out how frequently the interest is compounded. The more frequently interest is compounded, the more interest there is. It doesn’t matter if you’re paying interest or earning interest, compound interest is the usual method of figuring, and this makes interest grow faster.