Compound interest

What it means

Compound interest is a way of calculating interest in which each period's interest is added to the principal and itself earns interest in the next period, producing interest on interest. With simple interest, by contrast, interest is always calculated on the original principal only. Over short periods the difference is small, but over long periods and at higher rates it is dramatic.

The result depends on how often interest is credited. At the same nominal annual rate, monthly compounding yields more than annual compounding. That is why offers are compared using the effective annual rate, which accounts for frequency, and for consumer credit the APR, which includes fees as well.

Compound interest is the foundation of financial mathematics. Calculations of future and present value, annuity loan repayments, the net present value of investments and returns on long-term savings all rely on it. The well-known rule of 72 says that at r percent a year money doubles in roughly 72 divided by r years.

How it works in practice

For companies, compound interest matters in investment and financing decisions. When evaluating an investment, future cash flows are converted to present value using a discount rate, the reverse of compounding. The further away a receipt is, the less it is worth today.

With loans, compounding works against the borrower if interest is not paid but capitalised, for example during a payment holiday or with some shareholder loans. The debt then grows faster than the nominal rate suggests. Contracts should be checked for whether interest is added to principal and how often.

For a company's spare cash, for example in term deposits or bonds, compounding increases the return if interest is reinvested. In a long-term reserve, such as for replacing assets, even a small difference in rate and compounding frequency creates a significant difference over the years.

What to watch out for

Mind the ban on interest on interest in some situations. For late payment interest, Slovak law generally does not allow interest on interest unless specifically agreed in business relationships, and consumer credit is subject to strict limits. Before enforcing a claim, check how interest is correctly calculated.

When comparing offers, the nominal rate is not enough. Compounding frequency, fees and whether interest is paid as it falls due or capitalised all matter. Over long periods seemingly small differences can amount to thousands of euros, so it pays to have offers recalculated on the same basis.