Compound interest

Compound interest is interest paid on the principal plus the interest that has accrued to date. This differs from simple interest, which is interest calculated on the principal only. For instance, a $5,000 deposit that pays 5 percent simple interest annually will pay $250 by the end of one year and $1,250 in interest by the end of five years for a total balance of $6,250. But if an account pays 5 percent compounded annually, then accrued interest is added to the principal each year and the new interest is calculated based on that amount. Therefore, if the account compounds the interest annually, the investor would have a total of $6,381 at the end of five years. The more frequently interest is compounded, the higher the ending balance. If, in this example, the interest is compounded monthly the total balance at the end of five years would be $6,417.

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