How Does Compound Interest Work?
Without interest, your money doesn’t grow.
If you keep cash in a shoe box at home for a rainy day, your total amount won’t increase unless you add more to it.
That also means the 50 bucks you borrowed from your sister won’t go up to $75 when it’s time to pay her back next Friday.
But if you were to keep your savings in a bank account or take a loan from a payday lender, the outcome would be different. You’ll see an increase to your savings — or what you owe.
That’s all due to compound interest — but what is it and how does compound interest work?
What Is Compound Interest?
Compound interest is a basic financial concept that explains how your money can grow exponentially. Your balance increases by earning interest on the interest.
A bit confusing, we know. So let’s break it down with a personal finance example.
If you had $1,000 in an account earning 5% interest on an annual basis, you’d end up with $1,050 at the end of the year. If your interest is compounded, you’d earn 5% of your $1,050 balance — an additional $52.50 — by the end of the second year, leaving you with a total of $1,102.50.
Simple interest, on the other hand, is when you earn interest on your original balance only. Your interest earnings aren’t factored in when it comes to calculating interest in subsequent years.
If your $1,000 was in an account earning simple interest at the same 5% annual rate, you’d still have $1,050 at the end of the first year. However, at the end of year two, you’d only earn interest based on the $1,000 you initially put in there, not on the $1,050. You’d earn another $50 instead of $52.50, leaving you with a balance of $1,100.
Now, an extra $2.50 is far from a big deal, but let’s say you left that money in your account for 20 years instead of two. With compounding interest, you’d have $2,653.30 at the end of 20 years. Using simple interest, you’d only have $2,000.
How to Calculate Compound Interest
While there is a fancy formula to determine how your money grows with compound interest, we’ll let you in on a secret. You can find a bunch of compound interest calculators online — including this one from the U.S. Securities and Exchange Commission.
Just plug in your initial investment, how long you plan to save, your interest rate and how often the interest is compounded, and voila!
If you’re curious — or have a thing for algebraic equations — the compound interest formula is to calculate:
A = the total amount you’ll end up with
P = the principal amount (what you start off with)
r = annual interest rate (as a decimal)
n = number of times the interest compounds in a year
t = time in years
The math is much easier to calculate if you just want to find out how many years it would take for your money to double using compound interest. Using what’s known as the rule of 72, you divide 72 by the annual interest rate (not written as a decimal).
If your savings of $1,000 earns 6% interest annually, it’d take 12 years for your money to grow to $2,000.
Additionally, you can use the rule of 72 to figure out what interest rate you’d need to earn in order to double your money in a certain number of years. You’d calculate that by dividing 72 by the number of years.
For instance, for your money to double while compounding in 8 years, you’d need a 9% annual interest rate.
How to Make the Most of Compound Interest
Understanding the different factors that affect your money’s growth can help you take advantage of the power of compound interest.
Snag a Great Rate
It’s pretty obvious that the higher interest rate you get, the higher your returns. But how do you score the best interest rate out there?
If you’re putting money in a savings account, look for a high-yield savings account — one that exceeds the national average of 0.05% interest. Online banks often provide better rates, because they don’t have the overhead costs that brick-and-mortar banks do. That doesn’t mean traditional banks aren’t offering competitive rates though.
Interest rates from money market accounts can rival some high-yield savings accounts, so that’s another option.
If you open a certificate of deposit (or CD), the interest rate is usually greater when you choose a longer maturity term. But make sure you are okay with leaving your money untouched for that long. You are charged fees for pulling money out of a CD before its maturity date.
If you’re investing in the stock market, your earnings are technically returns, not interest, but the concept is similar. Personal finance experts say you can expect average returns ranging from 6% to 10% when you invest long term. However, the stock market is volatile and involves more risk.
The Early Bird Gets the Bigger Worm
The longer you let your savings sit, the greater compounding can work in your interest (pun intended).
If you put $1,000 in an account earning 5% interest, compounded annually, at age 25, that money would grow to $7,039.99 by age 65. If you saved the same amount at the same rate at age 35, you’d have $4,321.94 when you turned 65. If you waited until you were 45, you’d only have $2,653.30 by age 65.
Save sooner rather than later to truly benefit from compound interest.
Don’t Stop Saving
It can be tempting to drop money into an interest-bearing account once and just let the magic of compound interest do its thing. But you’ll benefit more — a lot more — if you regularly add to your savings account.
Remember the $1,000 from the previous example that grew through compounding to $2,653.30 at the end of 20 years?
Let’s say you had only half that much to start, but you committed to depositing $10 into your account every month as an investment. That money, earning compound interest on your $500 initial principal plus the $10 you put in month after month, for 20 years, would grow to $5,294.56.
By making the $10 monthly deposits, you’ll have invested $2,900 of your own money over 20 years — and earned $2,394.56 in interest which can go a long way in retirement. When you initially save $1,000 and make no additional contributions, you only earn $1,653.30 in interest.
So keep putting away money, even if it means a little at a time.
Consider the Frequency
How often interest earnings are calculated also plays a big role in how much you can save.
Our earlier examples were based on interest that was compounded once a year. However, interest can be compounded at other regular frequencies, such as monthly or daily.
Compounding frequency can also be discussed in terms of compounding periods. If interest is compounded monthly, you’d have 12 compounding periods in a year. If it’s compounded daily, you’d have 365 compounding periods in a year.
Using the same example of $1,000 in an account earning 5% interest, here’s what you’d end up with after 20 years at different compounding frequencies.
- Annually: $2,653.30
- Monthly: $2,712.64
- Daily: $2,718.10
The more often interest is compounding, the greater your savings will grow.
And just because your bank only drops your interest earnings into your account once a month, doesn’t mean the interest is compounding monthly. Many financial institutions that compound interest on a daily basis wait until the end of your monthly statement period to tack on those earnings.
Another important note: When you come across interest rates advertised by a bank, financial institution or lender, the APY (or annual percentage yield) takes compounding frequency into effect while the APR (annual percentage rate) does not.
How Can Compound Interest Be A Disadvantage?
While compound interest can be a significant savings boost, it’s not all rainbows and roses. Compound interest is also the reason why you never seem to get your head above your credit card debt while making minimum payments.
Just as your savings balance grows when interest is compounding, so does the debt balance of what you owe.
When you make a credit card purchase or take out a personal loan, your lender will charge you interest, which is added to your balance. You’ll then be charged interest based on your new balance — the original amount plus the interest accrued (minus any payment you’ve made).
Compound interest can really hurt you in the case of negative amortization. That’s when your monthly payment is less than the interest that accrues over that period, and your outstanding balance increases instead of going down.
When you take out a loan or open a new credit card, here are four things to keep in mind:
Score the lowest interest rate you can. Increasing your credit score will usually result in lenders offering you lower interest rates.
Keep your lending period short. You’ll pay less interest with a three-year car loan than you will with a five-year loan.
Pay more than the minimum. If you dig through your credit card statements, you’ll see a section that details how long it’d take to pay off your balance if you only made minimum payments and how much you’d pay in interest compared to what it’d take to pay your balance off in three years and how much you’d save.
Make biweekly payments. You’ll end up putting more money toward your principal balance and pay less in interest by making payments on your debt every two weeks rather than once a month.
Not all lenders compound the interest they charge. Interest calculated for a mortgage loan, auto loan or federal student loan will usually be simple interest — interest based solely on your original, principal loan amount.
We hope this article was helpful in learning about compound interest!
Nicole Dow is a senior writer at The Penny Hoarder.