What is Compound Interest?

Compound interest is interest that is calculated based on both the outstanding principal and any interest that accumulated in prior periods. It may be calculated several times a year, such as on a monthly or quarterly basis. A greater degree of calculation frequency equates to a more rapid rate of growth in the amount of interest. This is because interest is being compounded on top of existing interest. Thus, a loan that compounds monthly will require larger periodic payments than one that compounds on a quarterly basis.

When compounding is used, the amount of interest calculated greatly exceeds the amount derived under a simple interest calculation (where interest is derived only from the amount of principal). This can be a major concern when compounding is introduced into the calculation of a consumer loan, since the consumer will end up paying far more interest than would have been the case if a simple interest calculation had been used instead.