RealTown Words

Interest computed on the principal sum plus accrued interest. At the beginning of the new interest period, all interest is added to the principal, forming a new principal figure on which interest is then calculated. This process repeats itself each interest period—interest compounding daily, monthly, semiannually, or annually. Thus, on a $1,000 savings account at 5 percent interest compounded annually, for the first year the amount of interest is $50. In the second year, the new principal balance is $1,050, thus making the second-year interest $52.50.

Some states specifically prohibit (as usurious) actions to recover compound interest on loans, so that contracts charging interest on interest cannot have the extra interest enforced. However, after simple interest has become due, interest upon it may be contracted for and collected under a new special agreement.