Compound interest can be defined as an interest that is earned on the principle amount and the interest that is previously earned on that amount.
The Example of Compound Interest
In order to understand the idea of the compound interest let’s assume that an individual placed an amount of $100 in the saving account of a XYZ bank. The interest rate on the amount is 5 percent so if the individual is enjoying compound interest the amount that will be accumulated in the account after five years will be:-
If the bank is giving 5 percent on an amount of 100 then at the end of the year the amount of the individual in the bank will be $105 on 31st of December. Now if the account has 105 dollars then at the end of the next year the total amount in the account will be as under:-
105 x 1.05 = $110.25
This means under the system of compound interest the individual is not only enjoying interest on the principle amount of 100 dollars but also enjoying interest on the interest earned on that amount. Assume you carry the same model for the next eight years then the amount accumulated at the end of the 8th year will be shown as under:-
At the end of the 10th year amount the individual will get after enjoying the formula of compound interest will be $162.89. The example assumes that the bank is paying the interest at the end of each year however in real life the bank adds the interest each month in the account of the individual or any other business entity.
Importance of Compound Interest
The term compound interest is also referred as the magic in the world of finance and banking because it is one of the most fundamental methods to multiply the money and the wealth of individuals and business entities.