Compound Interest is a type of interest rate where the interest amount is calculated using the principal amount and the previous months’ interest rates. The compound interest works on the concept of “Interest on Interest” and is well applicable to both investments and loans.
The frequency of compounding determines the rate of the compounding interest. If the number of periods is high then the interest rate also increases. The interest on the interest generated more money and when the interest is compounding every month the returns would be higher than what you get when the compounding frequency is once a year. Hence the compounding frequency makes a significant difference to your total amount.
For example, if you have invested AED 10,000 at an interest rate of 10% for a period of 10 years.
If the compounding frequency is annually then at the end of the tenure your total amount will be AED 25,937.42 whereas if the compounding frequency is monthly then at the end of the tenure your total amount will be AED 27,070.41.
Also, the compounding interest tends to multiply largely when left for more time. Thus investments work on the concept of compound interests which will multiply the wealth and even larger when left for a long term.
But the compounding interest works against you in the case of loans. The reason is the same as the interest rate keeps multiplying, the overall loan value keeps increasing.
Compound interest = P (1+r/n)^nt
P = Principal Amount
r = Rate of Interest
t = Tenure or Compounding Period
n = number of compounding periods per year
You can use the formula to calculate the compounding interest or simply use the Compound Interest Calculator.