Compound interest is one of the interest rates existing in financial terms. The word interest refers to the profit that a capital produces. This capital can be borrowed or deposited and in either of the two cases generate interest.
- Capital deposited. A deposited capital is in a checking account or deposit of a financial institution and produces a return to its holder.
- Borrowed capital. This type of capital is that which a financial institution has lent in a mortgage transaction and for which it receives remunerative interest from the debtor.
Interest is therefore used to measure the profitability of an investment or savings, or to calculate the cost of a loan.
Characteristics of compound interest
Compound interest is characterized in that the amount corresponding to the interest is added to the outstanding principal or principal. Therefore, interest also generates more interest. Something that does not happen with him interés simple.
This is the usual case of bank deposits, in which the remunerative interest is paid into the same account where the capital is, subsequently generating positive interest on said amounts.
Due to the accumulation characteristics of compound interest, it does not remain constant during the term of the loan or investment. Since it is not calculated using principal as a reference, compound interest increases over time.
Formula for calculating compound interest
The formula to calculate the compound interest generated by a principal for complete periods of one year is as follows:
Final Capital by Compound Interest = C x (1 + I) T
This formula allows us to obtain the final capital obtained with compound interest.
Where the values of the formula are:
- C: is the amount of the initial capital on which the compound interest calculation is made.
- I: is the interest rate. It is usually expressed as a percentage, so before including it in the formula we will divide it by 100.
- T: is the number of periods during which the borrowed or invested capital will be maintained, expressed in full years.
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