Compounded monthly refers to the process of calculating interest on both the initial principal and the accumulated interest from previous periods. In simpler terms, it means that the interest you earn each month is added to your principal, and the next month’s interest is calculated on this new amount.
For example, if you have a savings account with a 12% annual interest rate compounded monthly, the interest is calculated and added to your account every month. This means that each month, you earn interest not just on your original deposit, but also on the interest that has been added in previous months.
Here’s a breakdown of how it works:
- Principal: The initial amount of money you deposit or invest.
- Interest Rate: The percentage of the principal that is paid as interest over a specific period, usually a year.
- Compounding Frequency: How often the interest is calculated and added to the principal. In this case, it’s monthly.
Mathematically, the formula for compound interest compounded monthly is:
A = P (1 + r/n)^(nt)
Where:
- A = the future value of the investment/loan, including interest
- P = the principal investment amount (the initial deposit or loan amount)
- r = the annual interest rate (decimal)
- n = the number of times that interest is compounded per year
- t = the number of years the money is invested or borrowed for
Using the example above, if you invest $1,000 at a 12% annual interest rate compounded monthly for 1 year, the calculation would be:
A = 1000 (1 + 0.12/12)^(12*1)
This would result in a future value of approximately $1,126.83.
In finance, compounding monthly can significantly increase the amount of interest you earn over time compared to simple interest, where interest is only calculated on the principal amount.