Compound Interest and Present Value

In business, another common way of calculating interest is by using a method known as compounding, or compound interest, in which the interest calculation is applied a number of times during the term of the loan or investment. Compound interest yields considerably higher interest than simple interest does because the investor is earning interest on the interest. With compound interest, the interest earned for each period is reinvested or added to the previous principal before the next calculation or compounding. The previous principal plus interest then becomes the new principal for the next period. As this compounding process repeats itself each period, the principal keeps growing by the amount of the previous interest. As the number of compounding periods increases, the amount of interest earned grows dramatically, especially when compared with simple interest. The idea that money “now,” or in the present, is more desirable than the same amount of money in the future because it can be invested and earn interest as time goes by. Money now or in the present, is more desirable than the same amount of money in the future because it can be invested and earn interest as time goes by.