Compound Interest Definition

Compound interest denotes a calculation methodology which uses a defined time period, usually one month, over which annual interest is repeatedly calculated. For example, on a typical credit card with an annual interest rate of 18%, the interest on the balance due is not calculated only once each year, but instead is calculated every month, using 1/12 of the 18% annual rate, or 1.5% for each month. This causes the principal to compound with the monthly interest, and the sum is then subjected to the next month’s interest calculation. This process also applies to savings accounts. For example, you may have often heard your penurious but rich uncle speak about "The miracles of compounding interest" with nearly religious fervor; a mathematical example will explain his devotion:

  • If you deposit $600,000 in a retirement account paying 5% annual interest, and the interest is paid only once at the end of a 20-year period, you would receive back the $600,000 principal plus interest of $600,000; you’d be a millionaire!
  • If you deposit $600,000 in a retirement account paying 5% annual interest, and the interest is compounded monthly, at the end of a 20-year period you would receive back the $600,000 principal plus interest of $1,627,584; you’d be a multi-millionaire!