Accounting Dictionary

Compound Interest

Compound interest is interest computed at regular intervals so that bank depositors are receiving interest on the interest they earn.

If you put $100,000 in the bank at 12% simple interest for 6 months, the calculation is as follows: $100,000 x .12 yearly interest = $12,000 for a whole year or half of that, $6000 interest, for a half year.
If instead the interest is compounded monthly the calculation is as follows:

Principal Yearly Interest Monthly interest
$100,000 (100,000 x .12) = $12,000 ($12,000 /12) =1,000
(100,000 + 1000 interest) =$101,000 (101,000 x .12) = $12,120 ($12,120 /12) =1,010
(101,000 + 1010 interest) =$102,010 (102,010 x .12) = $12,241 ($12,241 /12) =1,020
(102,010 + 1020 interest) =$103,030 (103,030 x .12) = $12,363 ($12,363 /12) =1,030
103,030 + 1030 interest) =$104,060 (104,060 x .12) = $12,487 ($12,487 /12) =1,040
(104,060 + 1040 interest) =$105,100 (105,010 x .12) = $12,612 ($12,612/12) =1,051
TOTAL INTEREST $6,151
You get $151 more in interest because you got interest on your interest. If you have a mortgage, you pay more interest because the interest you OWE is compounded monthly.

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