Interest-on-interest is also referred to as compound interest. It is the interest earned when interest payments are reinvested. The golden rule to remember here is that interest on interest is good for investments and savings. However, it’s bad for loans.

Let’s explain interest on interest with a simple example. Assume that you invest Rs. 5000 in a fixed deposit. The FD earns 5% interest per year. If the fixed deposit uses interest on interest then,

• In the first year, the FD earns interest on the principal (Rs. 5000).
• In the second year, the FD earns interest on the principal + the interest gained in the first year.
• In the third year, the FD earns interest on the principal + interest earned on the first year + interest earned on the second year.

Compare this with simple interest. If it’s simple interest, here are the returns, the same FD would fetch.

• In the first year, the FD earns interest on the principal (Rs. 5000).
• In the second year, the FD earns interest on the principal (Rs. 5000).
• In the third year, the FD earns interest on the principal (Rs. 5000).

As you can see, compound interest makes your savings grow faster and rapidly. Now, let’s see how compound interest is calculated.

The formula for calculating compound interest is  A = P (1 + r/n) ^ nt

In this formula, P is the principal amount, r is the rate of interest per annum, n denotes the number of times in a year the interest gets compounded, and t denotes the number of years.