Compound Interest Definition and Legal Meaning

On this page, you'll find the legal definition and meaning of Compound Interest, written in plain English, along with examples of how it is used.

What is Compound Interest?

History and Meaning of Compound Interest

Compound interest is a financial term that has been in use for centuries, dating back to the ancient civilizations of Babylon and Egypt. It refers to the interest that is calculated not just on the principal amount of a loan or investment, but also on the accumulated interest that has been earned over time. This means that the interest is reinvested, leading to a compounding effect that can significantly increase the total amount of interest earned or owed.

In modern times, compound interest is commonly used in banking and investment contexts, where it is often calculated and added to the balance of a savings account or investment portfolio at regular intervals. The compound interest rate can vary depending on factors such as the length of the investment, the frequency of compounding, and the interest rates offered by different financial institutions.

Examples of Compound Interest

1. John invests $10,000 in a savings account that earns 5% interest per year, compounded annually. After one year, he will have earned $500 in interest, bringing his total balance to $10,500. In the second year, he will earn 5% interest not just on the original $10,000, but also on the additional $500 of interest he earned in the first year. This means he will earn $525 in interest in the second year, bringing his total balance to $11,025.

2. Emily takes out a $100,000 mortgage loan at a 4% annual interest rate, compounded monthly. Each month, the interest is calculated based on the outstanding balance of her mortgage, including any interest that has accrued since her last monthly payment. Over the course of 30 years, the compounded interest on her loan will add up to over $71,000, meaning she will have paid a total of over $171,000 for her home.

3. Sally invests $5,000 in a mutual fund that has an average annual return of 8%, compounded quarterly. After one year, she will have earned $408 in interest on her investment. However, because the interest is compounded quarterly, she will also earn interest on the interest every three months, leading to an even greater return on her investment over time.

Legal Terms Similar to Compound Interest

1. Simple interest: Interest that is calculated only on the principal amount of a loan or investment, and not on any accumulated interest.

2. Annual percentage rate (APR): The total cost of borrowing money over the course of a year, including any fees or charges in addition to the interest rate.

3. Usury: Charging an excessively high interest rate on a loan, usually above the legal limit set by the government or financial institution.