Compound Interest
Compound interest, or interest that is added to the of an account, is a critical factor in many areas modern financing, including . Compound interest is often characterized as having a 'snowball effect,' because over a longer period of time it can have a significant impact on the balance of an account.
General Example
The concept of compound interest involves the recursive accrual of money. For example, let's say an individual opened a monetary account that saw interest compounded on a monthly basis. He or she opened the account in January with an initial monetary deposit. In February, a fractional interest payment would be added to the balance based on the initial deposit, and would thus marginally increase the principal balance. The March interest payment would be calculated based on the initial deposit plus the interest accrued in February. So this payment is said to be compounded into the principal balance, and would nudge the principal balance up a little higher.
This pattern would continue until this account closes or the balance is reduced to zero. Any money withdrawn from the account would negatively affect the principal balance, and thus the amount of interest accrued each month. If no money was ever withdrawn from the principal balance it would continue to increase at ever more noticeable levels. For the first few years the increases would be barely noticeable, but eventually they would appear quite dramatic.
Compound Interest and Mortgages
In the context of , compound interest often comes into play when a pays slightly more than his or her minimum monthly payment each month. The extra amount is applied to the principal balance, which then fractionally reduces the amount of interest required the next month. Because the minimum monthly payments of a mortgage are usually fixed, the amount applied to principal will gradually increase, even if no more than the minimum payment is applied going forward.
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