compound interest
Compound interest refers to interest earned both on prior interest from prior periods and the initial principle of an investment. This occurs where an investor continuously earns interest on an outstanding debt owed to them or an investment compounds in value. This is in contrast to simple interest where an investor receives the same amount of interest at every interval. Compound interest is a foundational part of modern-day financing and trading. Because compound interest allows investment returns to grow exponentially, it allows investment returns to grow faster compared to simple interest-based investment returns.
A formula for calculating the total cost of the loan including compound interest is FV=PV(1-i)n where FV is the future value of the investment, PV is the present value, i is the interest rate, and n is the number of periods interest is applied.
For example, Monica could give a $1,000 loan to John with a monthly interest rate of 10%, and John decides to pay Monica back in ten months. Under compound interest, John would owe Monica $2,593.74 ($2,593.74 = $1,000(1+.10)10). However, under simple interest, John would only owe Monica $2,000 ($2,000 = $1,000 + ($100*10).
To simplify the calculation of compound interest, financial institutions typically offer an Annual Percentage Yield (APY), which shows the total investment returns, including the interests compounded during the investment period.
See investor.gov for more examples and a compound interest calculator .
[Last reviewed in January of 2025 by the Wex Definitions Team ]
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