When money is deposited in a bank, it commonly attracts interest; in a similar way, a borrower must normally pay interest on money borrowed. In this sub-topic, we will learn compound interest in relation to simple interest.

The money borrowed is called the principal, usually denoted by P.

The extra money paid is called interest, usually denoted by I.

The amount of interest depends on the principal; that is the interest is certain percentage of the principal. This percent is called the rate of interest, or rate.

When money is borrowed, the borrower agrees to pay back the principal and the interest within a specified period of time.

There are two basic ways of calculating the amount of interest paid on money deposited: simple interest and compound interest.

Simple Interest

If simple interest is paid, interest is calculated only on the principal P, the amount deposited (the original capital sum).

Compound Interest

When the interest due at the end of a certain period is added to the principal and that sum earns interest for the next period, the interest paid is called compound interest. This is when interest is added (or compounded) to the principal sum so that interest is paid on the whole amount. Under this method, if the interest for the first year is left in the account, the interest for the second year is calculated on the whole amount so far accumulated.