Compound Interest

July 30, 2009

Compound interest is an economic concept where accumulated interest is added once again to the principal amount, which means interest is added on top of interest from then onwards. The act where interest is declared to be principal in this way is known as compounding, because the interest is compounded. For example, a loan will have interest compounded each month, adding up to the balance at the end of the month.



Compound interest rates are of great importance to individuals and businesses alike, but in order for them to be useful, the compound interest rates of one financial institution needs to be comparable to another. This can only be achieved by the interest rate, along with the frequency of the compounding, being disclosed by the institution. Many governments, therefore, require that financial institutions issue a comparable yearly interest rate for all their advances and deposits. Compound rates are also known as annual percentage yield, the effective annual rate, annual percentage rate, effective interest rate, along with a few other terms.

Simple interest is the opposite of compound interest, and is where interest isn’t added to the initial principal, and there is therefore no compounding involved. Compound interest, however, is the more dominating type of the two when it comes to economics and finance. Simple interest is not used very often, but some financial products contain some aspects of simple interest.


The effects of compound interest being applied to a principal amount depends on the periodic interest rate that is applied, in addition to the frequency of the compounding. In order to accurately predict the amount that needs to be paid with interest, the compounding frequency needs to be established. This can be daily, monthly, quarterly, half-yearly or yearly. The interest rate also needs to be specified. Depending on the country in question, its government policies and monetary institutions, different conventions will be used. A few things remain the same, regardless of the country in question, and these are the nominal annual rate, the periodic rate, and the effective annual rate.

The periodic rate is the interest charged, and therefore, compounded, during each period. This rate is important in the calculations involved in compound interest, but is not very useful for comparing interest rates. The periodic rate, be definition, is the annual nominal rate over the total number of compounding periods every year.

The nominal annual rate or nominal interest rate is the annual rate, before adjustments are made for compounding. The effective annual rate is the nominal annual rate after it has been adjusted for compounding so as to allow any comparisons to be made.



Generally, economists tend to use the effective annual rates in order to make their comparisons of compound interest rates. When it comes to commerce and finance, however, it is the nominal annual rate that is the most useful to economists. If a loan with a set annual nominal rate is quoted with its compounding frequency, the annual rate can be properly specified. In this way, the effect of the interest can be determined quite precisely. It cannot, however, be compared to other loans, if they have a different compounding frequency.

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Written by Uncle Sam · Filed Under Mortgage and Loan 

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