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Compound interest

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Compound interest is the process of earning interest on both an initial principal sum and the interest that has already accumulated.

Compound interest
Compound interest

This occurs when a person reinvests or retains interest instead of having it paid out. It can also apply to the accumulation of debts for a borrower. Compound interest is different from simple interest. In simple interest, the accumulated interest is not added back to the principal for the next period. Because the interest grows on a larger base each time, the total amount increases more rapidly. This concept is vital for understanding how savings grow and how loans increase over time.

The speed of this growth depends on the compounding frequency. Compounding frequency is the number of times interest is capitalized within a specific unit of time. This happens on a regular basis. The frequency can be yearly, half-yearly, quarterly, monthly, weekly, or even daily. It can also occur continuously. For example, if interest is expressed as an annual rate but compounded monthly, the frequency is 12.

Compound Interest with Varying Frequencies
Compound Interest with Varying Frequencies

This means the interest is calculated and added to the principal every month. Higher frequencies generally lead to higher total amounts over time.

To help consumers compare different financial products, many countries require specific disclosures. Financial institutions must often show the annual compound interest rate on a comparable basis. This is frequently called the Annual Equivalent Rate (AER) or the effective annual percentage rate (EAPR). Another term used is the annual percentage yield. The effective annual rate represents the total accumulated interest payable by the end of one year, divided by the principal sum.

These rates often include the annualized compound interest rate along with other costs like taxes or fees.

History shows that humans have grappled with these math problems for millennia. Traces of mathematicians analyzing compound interest appear in the medieval era. However, a clay tablet from Babylon, dating from 2000 to 1700 B.C., may show the first recorded compound interest problem. In ancient times, the practice was controversial. When lenders charged compound interest, it was often viewed as the worst kind of usury. Because of this, it was severely condemned by Roman law and the common laws of many other nations.

As math progressed, specialized tools for calculation emerged. In about 1340, a Florentine merchant named Francesco Balducci Pegolotti included a compound interest table in his book, *Pratica della mercatura*. His table showed interest on 100 lire at rates from 1% to 8% for up to 20 years. In 1494, Luca Pacioli published *Summa de arithmetica*, which included the Rule of 72. This rule allows one to estimate how many years an investment takes to double by dividing 72 by the interest rate.

Inflation compounded over 40 years
Inflation compounded over 40 years

Later, in 1613, Richard Witt published *Arithmeticall Questions*. This was a landmark book because it was entirely devoted to the subject, which was then called anatocism. Witt was a London mathematical practitioner who provided 124 worked examples and high accuracy.

Mathematical complexity increases when looking at continuous compounding. This occurs when the number of compounding periods per year increases without limit. In this scenario, the effective annual rate approaches an upper limit.

Annual dividend
Annual dividend

Mathematicians use the "force of interest" to describe this continuous rate. This concept is a natural consequence of Itô calculus, where financial derivatives are valued at an ever-increasing frequency. As the frequency approaches a limit, the derivative is valued in continuous time. This makes continuous compounding mathematically simpler for valuing complex instruments like derivatives.

Compound interest connects to many different systems in modern life. It is seen in corporate and government bonds, where interest is usually paid twice a year. In these cases, the six-month payment is the disclosed rate divided by two, multiplied by the principal. Canadian mortgage loans often use semi-annual compounding with frequent payments. In contrast, many U.S. mortgages use an amortizing loan system. These use an amortization schedule to apply payments toward the principal and interest. Instead of adding interest to the principal, the interest is paid off monthly through regular payments.

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