Definition of Compound Interest

Compound interest is a concept that is calculated on the principal and interest unlike simple interest that is calculated on principal value. To understand the difference between simple interest and compound interest.

Let’s take an example:

You have $5,000 to invest in a bank that has two investment plans. The first option is that you will invest $5,000 for five years at 10% and you can withdraw interest every year. This is an example of simple interest.

Simple interest = $5,000 x 10% x 5 years = $2,500

The second option is that you will deposit $5,000 for five years and you will earn 10% interest compounded annually. In this, you will not be able to withdraw the interest because that will be reinvested.

Compound interest = $5,000 x [(1 + 10%) ⁵ – 1] = $3,052.55