Business Glossary

rate that is applicable when interest in subsequent periods is earned not only on the original principal but also on the accumulated interest of prior periods. For example, assume that the initial principal is $1000 and annual interest rate is 10%. At the end of first year, the amount is the principal and interest, which is $1000 + .1($1000) = $1000 + $100 = $1100. At the end of second year, the amount is accumulated: $1100 + .1($1100) = $1100 + $110 = $1210.

interest earned on principal plus interest that was earned earlier. If $100 is deposited in a bank account at 10%, the depositor will be credited with $110 at the end of the first year and $121 at the end of the second year. That extra $1, which was earned on the $10 interest from the first year, is the compound interest. This example involves interest compounded annually: interest can also be compounded on a daily, quarterly, half-yearly, or other basis.

interest added to interest previously earned on a principal balance. Compounding increases the depositor's rate of return on bank balances and the lender's effective yield on the unpaid principal of outstanding loans. For example: take a $1,000 savings account paying 5% interest, compounded monthly; the effective rate earned is 5.116%, assuming the $1,000 remains on deposit for a full year and no additional deposits are made. The more frequently interest is compounded, the higher the effective rate earned. Contrast with simple interest , where interest is computed only on the original principal.

*Amount paid on $1,000 at 5% annual interest rate.

Source: John R. Brick, ed., Bank Management (Richmond, Virginia: Robert F. Dame, Inc., 1980), p. 475.

interest earned on principal plus interest that was earned earlier. If $100 is deposited in a bank account at 10%, the depositor will be credited with $110 at the end of the first year and $121 at the end of the second year. That extra $1, which was earned on the $10 interest from the first year, is the compound interest. This example involves interest compounded annually; interest can also be compounded on a daily, quarterly, half-yearly, or other basis.

accumulation of interest yearly or more frequently, including interest paid on interest.

interest paid on the original principal and also on the unpaid interest that has accumulated. Contrast with simple interest .

Example: $100 deposited in a 5% savings account earns $5 interest the first year. Its second-year earnings are 5% of $105, or $5.25. Each year, interest is received on previously earned but undistributed interest, so interest compounds.