Compound interest

When the compound interest method is used, interest is calculated on the original principal plus all interest accrued to that point in time.

Since interest is paid on interest as well as on the amount borrowed, the effective interest rate is greater than the nominal interest rate.

The more often interest is compounded within a particular time period, the greater will be the effective rate of interest.

The compound interest rate method is often used by banks and savings institutions in determining interest they pay on savings deposits "loaned" to the institutions by the depositors.

Special cases

•	When interest is never compounded it is calculated on the original principal only. This type of calculation is called simple interest.
•	When the interval of time between compoundings approaches zero (even shorter than a second), then compounding is said to be continuous.

 

Related topic

Simple interest

Compounding and payment frequencies