-> compound interest
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- Compound interest is paid on the principal and on interest accumulated over the years. Compounding is a term that denotes the addition of interest. Interest compounds when the principal and the interest earned are reinvested. For instance, if you get 10 percent interest on a $1,000 investment, you will have $1,000 plus the $100 you reinvested. This is a simple example, but the point is that with time, you will earn more money with compound interest compared to simple interest. In simple terms, you start earning interest income and your money grows at a quick rate.
Three main factors have impact on the rate at which your investment will grow. If you invest in stock, the profit you earn will be the profit from dividends and capital gains. Another factor is the amount of time your money compounds. The longer you leave it to compound, the more you earn. The timing of taxes and the tax rate you will pay are also important. You end up with more if taxes are not due until the end of the compounding period. Thus, you may want to check accounts such as Roth IRA, traditional IRA, SEP IRA, 401(k), and others.
To be able to compare compound interest with other types of interest, the compounding frequency and interest rate have to be disclosed. Interest is a yearly percentage for many people. So, financial institutions in many countries are required to disclose the annual equivalent interest on advances and deposits. The equivalent rate is known as annual percentage yield, annual percentage rate, effective interest rate, and annual equivalent rate, among others. Then, when you get a loan, the bank charges you a fee, and the APR typically counts the compound interest and this cost as to convert to the equivalent rate. These requirements have been set in place by the government so that bank customers can compare the actual borrowing costs easily. Basically, there is an equivalent rate for all compounding frequencies.
Compared to compound interest, no compounding takes place with simple interest, meaning that interest is not being added to the principal Simple interest is used less frequently while compound interest is considered the standard in economics and finance. The effect of compounding depends on the frequency at which interest compounds. This frequency can be daily, monthly, half-yearly, etc. The effect of compounding also depends on the interest rate, which can be periodic rate or effective annual rate.
How to calculate compound interest? You only need a calculator and a pencil. For example, letís assume you have a principal amount worth $50,000 and the interest rate is set at 5 percent, compounded over three years. During the first year, you get $50,000 x .05 or $2,500 interest. The next year, you will have $52,500 x .05 or $2,625 interest. Finally, during the third year, you have $52,625 x .05 or $2631 interest. It is even easier to calculate simple interest. You have to multiply the principal by the time and the rate. You will see, however, that it pays to use compound interest rather than simple interest.
Keep in mind that monthly compounding is used for mortgages in the United States. The interest rate on government bonds and corporate bonds is often paid twice a year. The disclosed rate is lower than the compound rate. The former is divided by two, and the result is multiplied by the principal to find out the amount of interest to be paid. In addition, different formulas are used to calculate the interest on Canadian and US T-bills.