With Compound Interest, the interest is calculated on a base that accumulates (or compounds) each period, say each year. So, the amount you earn (or owe) each year increases. Using compound interest on our example above, with the same $1,000 base and 5% rate, in year one the 5% is calculated on the base of $1,000, which equals $50. No change there. In year two, that $50 is added to the base, so the same 5% interest is calculated on a base of $1,050. This means the amount you earn (or owe) is now $52.50. In year three, this is added to the base so the same 5% interest is calculated using $1,102.50 as a base. 5% times $1,102.50 equals $55.125.
Note: interest can be divided up and calculated daily, weekly monthly, annually, depending on the particular situation. We don’t go into that level of detail here. For now, we’re just introducing the basic concept. So, for you math wonks out there who want to argue about when the rate is charged and what is the difference between current yield and yield to maturity, you’ll have to wait until we write the chapter on fixed income securities.