Question

what is compounding of interest? Explain with examples.

Answer 1

Let us first understand the concept of simple interest.

It is a quick and easy method of calculating interest, interest is simply calculated by multiplying the rate of interest with the amount of loan (principal).

Mr.A borrowed $100000 from Mr.B and agreed to pay an interest at the rate of 12% per year on simple interest basis.Loan is repayable within 2 years

Formula calculate Simple interest is I (interest) = P (Principal) x I (Interest) x N (Period)

interest amount in Year 1 is $100000*12% = $12000

Interest amount in Year 2 is $100000*12% = $12000

in simple interest method interest is calculated only on principal amount

Compound interest method

it is the amount of interest calculated on initial (opening) principle amount which also includes all of the interest on previous periods of a loan. It means interest is calculated on (interest+principal). Interest amount gets accumulated to the principal value.

Compound interest formula = P (1+r)ⁿ - P Where, N = Period, P = Principal and R= Rate of interest

Find the compound interest on the amount of loan borrowed from Mr.A $100000 at the rate of 12% for 3 years

1st Year interest amount $100000(1+0.12)¹ -$100000 = $12000

2nd Year   interest amount $112000(1+0.12)-$100000 = $13440

3rd Year interest amount $125440(1+0.12)-$100000 =$15052

it is clear evident from the above example that the interest is calculated not only on the principal but also on the amount of interest which is accumulated to the principal amount.

Hope you understand the concept.If not please let me know through comments.

Thank you..