Compound Interest

When compound interest is used to compute for the interest in the borrowed money, the principal, the interest rate and the length of time that the money was borrowed were not just those that were taken into consideration. For compound interest, the interest that is applied on the principal for the compounding period is also used in the computation of the interest for the next compounding period.

To better illustrate how compound interest is being computed, here is an example. If $1000 was borrowed for three years at 3% each year and the interest rate is compounded annually, the computation for the first year would be, $1000 multiplied with 0.03 and multiplied by one year. This would give a result of $30 in interest for the first year.

For the second year, $30 is to be added to $1000, and the interest rate is computed as the 3% of $1030. For the second year, the interest that would be compounded into the account is $30.9. The same is also done for the third year that the money was owed. $30.9 is added to $1030, making the principal $1060.9. Three percent of the new principal is computed, making the interest for the third year $31.83. What this means is that for the third year, the person who owes the money has to pay a total of $1092.73 for the $1000 that was owed three years ago.

In that example, the interest that was compounded was computed annually. In some cases, the interest may also be computed quarterly, semiannually, or even monthly just like for credit cards.