How do we calculate compound interest?

Compound interest is the interest that is earned not only on the principal amount but also on the accumulated interest of a deposit or loan. It is a powerful tool for investors and borrowers, and its effects can be significant over time. In this blog post, we will explore how to calculate compound interest.

First, let’s define some key terms:

• Principal: The initial amount of money invested or borrowed.
• Interest rate: The percentage charged on the principal amount or earned on the invested amount.
• Time period: The length of time the investment or loan is held.
• Compound frequency: The number of times interest is added to the principal amount in a year.

Now, let’s look at an example to better understand how compound interest works

Suppose you invest €1,000 at an annual interest rate of 5% for five years, compounded annually. At the end of each year, the interest earned is added to the principal amount, and interest is then calculated on the new amount.

Here’s how to calculate the compound interest:

1. Calculate the interest earned in the first year. Interest earned = Principal x Interest rate Interest earned = €1,000 x 5% = €50
   
   
2. Add the interest earned to the principal amount. New principal amount = Principal + Interest earned New principal amount = €1,000 + €50 = €1,050
   
   
3. Repeat steps 1 and 2 for each year of the investment.
   Year 2 interest earned = €1,050 x 5% = €52.50
   Year 2 new principal amount = €1,050 + €52.50 = €1,102.50
   Year 3 interest earned = €1,102.50 x 5% = €55.13
   Year 3 new principal amount = €1,102.50 + €55.13 = €1,157.63
   Year 4 interest earned = €1,157.63 x 5% = €57.88
   Year 4 new principal amount = €1,157.63 + €57.88 = €1,215.51
   Year 5 interest earned = €1,215.51 x 5% = €60.78
   Year 5 new principal amount = €1,215.51 + €60.78 = €1,276.29
   
   
4. Calculate the total amount earned at the end of the investment period. Total amount earned = New principal amount – Principal Total amount earned = €1,276.29 – €1,000 = €276.29

In this example, the total amount earned is $276.29, which is the sum of the interest earned over the five-year period. The power of compound interest is evident here, as the total amount earned is significantly higher than the simple interest earned on the principal amount of $1,000.

In conclusion, compound interest is a powerful tool for both investors and borrowers. It is important to understand how it works and how to calculate it to make informed financial decisions. By taking advantage of compound interest, you can maximize your returns on investments and save money on loans.

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