There are two kinds of interest computed on monetary amounts: simple and compound. The difference between the two is with simple interest, you only earn interest on your original amount. On the other hand, with compound interest, you get interest on your original amount and all your past interests. This means your money grows faster with compounding interest.
In order to calculate compound interest, you need to know some basic terms. Principal is the amount you start with. In other words, it's the amount you're borrowing, investing or saving. Interest rate is the annual or yearly rate of interest, and the term or time is how long your loan is for, how long you're investing or how long you're saving.
To calculate the dollar amount of compound interest, you'll use the formula:
A = P(1 + i)^t
where A = the total amount you'll have or owe at the end, P = the original amount you started with (your principal), i = the annual rate of interest and t = time or term, or the number of years you're computing the interest over.
Suppose you borrow $1000 for 2 years at 10 percent compounded annually. This means, in terms of the formula, that P = $1000, i = 10 percent or 0.10 and t = 2.
Substituting this information into the formula yields:
A = $1000(1 + 0.10)^2 = $1000 * (1.10)^2 = $1000 * 1.21 = $1210
This means that at the end of 2 years, $1210 is owed. Since the original loan was for $1000, the $210 difference is the compound interest amount.