Compound interest

Definition

Compound interest is the interest on a loan or deposit that is calculated based on both the initial principal and the accumulated interest from previous periods. It results in interest being earned on interest, leading to exponential growth over time.

5 Must Know Facts For Your Next Test

1. Compound interest can significantly increase the total amount of debt over long periods.
2. The formula for compound interest includes principal, rate, and time as key variables.
3. Frequency of compounding (e.g., annually, semi-annually, quarterly) impacts the total amount of compound interest accrued.
4. Compound interest is commonly used in calculating the cost of long-term liabilities such as bonds and loans.
5. Understanding compound interest is crucial for pricing long-term liabilities accurately.

Review Questions

• What factors are included in the calculation of compound interest?
• How does the frequency of compounding affect the total amount of compounded interest?
• Why is it important to understand compound interest when pricing long-term liabilities?

Related terms

Principal: The original sum of money borrowed or invested before any interest is added.

Annual Percentage Rate (APR): The annual rate charged for borrowing or earned through an investment, which does not account for compounding within the year.

Nominal Interest Rate: The stated interest rate on a financial product without taking compounding into account.