The easiest way to learn the concept of compounding interest is to work through a compounding scenario using interest compounded annually.

**Why is Compounding Interest Confusing?**

Compounding interest can be confusing because the interest rate is often stated as an annual rate but then is compounded over a shorter period of time. If compounding isn’t done on an annual basis, you’ll need to adjust the interest rate by dividing the annual rate by the number of compounding periods per year.

**Compounding Interest and Principal**

If a business took out a loan payable in two years with an interest rate of 10% compounded twice per year this would mean that the 10% annual rate will need to be converted to 5% per period for four semi-annual periods. The amount of interest would be compounded, but for four periods instead of two. The compounding process is calculated as follows:

**Period 1**

Principal Amount $3,000

Interest at 5% $ 150

**Accumulated Year-End $3,150**

**Period 2**

Principal Amount $3,150

Interest at 5% $ 158

**Accumulated Year-End $3,308**

**Period 3**

Principal Amount $3,308

Interest at 5% $ 165

**Accumulated Year-End $3,473**

**Period 4**

Principal Amount $3,473

Interest at 5% $ 174

**Accumulated Year-End $3,647**

**What the Business Would Repay**

So, if a business took out a loan for $3,000 that was payable in two years with an interest of 10% compounded semi-annually, the business would need to repay $3,647 at the end of two years.

Elaine Allan, BA, MBA

Vancouver, BC, Canada