Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest. Compound interest is standard in finance and economics.
Compound interest is contrasted with simple interest, where previously accumulated interest is not added to the principal amount of the current period, so there is no compounding. The simple annual interest rate is the interest amount per period, multiplied by the number of periods per year. The simple annual interest rate is also known as the nominal interest rate (not to be confused with the interest rate not adjusted for inflation, which goes by the same name).
The compounding frequency is the number of times per year (or rarely, another unit of time) the accumulated interest is paid out, or capitalized (credited to the account), on a regular basis. The frequency could be yearly, half-yearly, quarterly, monthly, weekly, daily, or continuously (or not at all, until maturity).
For example, monthly capitalization with interest expressed as an annual rate means that the compounding frequency is 12, with time periods measured in months.
The effect of compounding depends on:
- The nominal interest rate which is applied and
- The frequency interest is compounded.
Annual equivalent rate
The nominal rate cannot be directly compared between loans with different compounding frequencies. Both the nominal interest rate and the compounding frequency are required in order to compare interest-bearing financial instruments.
To help consumers compare retail financial products more fairly and easily, many countries require financial institutions to disclose the annual compound interest rate on deposits or advances on a comparable basis. The interest rate on an annual equivalent basis may be referred to variously in different markets as annual percentage rate (APR), annual equivalent rate (AER), effective interest rate, effective annual rate, annual percentage yield and other terms. The effective annual rate is the total accumulated interest that would be payable up to the end of one year, divided by the principal sum.
There are usually two aspects to the rules defining these rates:
- The rate is the annualised compound interest rate, and
- There may be charges other than interest. The effect of fees or taxes which the customer is charged, and which are directly related to the product, may be included. Exactly which fees and taxes are included or excluded varies by country, may or may not be comparable between different jurisdictions, because the use of such terms may be inconsistent, and vary according to local practice.
- 1,000 Brazilian real (BRL) is deposited into a Brazilian savings account paying 20% per annum, compounded annually. At the end of one year, 1,000 x 20% = 200 BRL interest is credited to the account. The account then earns 1,200 x 20% = 240 BRL in the second year.
- A rate of 1% per month is equivalent to a simple annual interest rate (nominal rate) of 12%, but allowing for the effect of compounding, the annual equivalent compound rate is 12.68% per annum (1.0112− 1).
- The interest on corporate bonds and government bonds is usually payable twice yearly. The amount of interest paid (each six months) is the disclosed interest rate divided by two and multiplied by the principal. The yearly compounded rate is higher than the disclosed rate.
- Canadian mortgage loans are generally compounded semi-annually with monthly (or more frequent) payments.
- S. mortgages use an amortizing loan, not compound interest. With these loans, an amortization schedule is used to determine how to apply payments toward principal and interest. Interest generated on these loans is not added to the principal, but rather is paid off monthly as the payments are applied.
- It is sometimes mathematically simpler, for example, in the valuation of derivatives, to use continuous compounding, which is the limit as the compounding period approaches zero. Continuous compounding in pricing these instruments is a natural consequence of Itō calculus, where financial derivatives are valued at ever increasing frequency, until the limit is approached and the derivative is valued in continuous time.
- US and Canadian T-Bills (short term Government debt) have a different convention. Their interest is calculated on a discount basis as (100 − P)/Pbnm,[clarification needed]where P is the price paid. Instead of normalizing it to a year, the interest is prorated by the number of days t: (365/t)×100. (See day count convention).Ofer Abarbanel – Executive Profile
Ofer Abarbanel is a 25 year securities lending broker and expert who has advised many Israeli regulators, among them the Israel Tax Authority, with respect to stock loans, repurchase agreements and credit derivatives. Founder of TBIL.co STATX Fund.