Q1: What is compound interest and how does it work?
Compound interest is interest calculated on the initial principal and also on the accumulated interest from previous periods. Unlike simple interest, compound interest allows your investment to grow exponentially over time because you earn interest on both your original investment and the interest it has already earned.
Q2: How does compounding frequency affect my returns?
The more frequently interest is compounded, the higher your returns will be. For example, monthly compounding (12 times per year) will yield more than annual compounding (1 time per year) because interest is calculated and added more frequently, allowing it to compound on itself more often.
Q3: What is the difference between compound interest and simple interest?
Simple interest is calculated only on the principal amount, while compound interest is calculated on the principal plus previously earned interest. Over time, compound interest significantly outperforms simple interest, especially for long-term investments.
Q4: How do I calculate compound interest manually?
The formula for compound interest is A = P(1 + r/n)^(nt), where A is the final amount, P is the principal, r is the annual interest rate (as a decimal), n is the number of times interest compounds per year, and t is the time in years.
Q5: What is the best compounding frequency for investments?
Generally, more frequent compounding (daily or monthly) is better for investors as it maximizes returns. However, the actual difference between monthly and daily compounding is usually small. The interest rate and time period have a much larger impact on your final returns.
Q6: Can compound interest work against me?
Yes, compound interest works both ways. When you borrow money, compound interest increases the total amount you owe over time. This is why credit card debt and loans can become expensive quickly if not paid off promptly. Always understand the compounding terms before borrowing.