How Does Compound Interest Work? We Explain in Plain English
Would you rather have $10,000 today, or a penny a day that doubles in value every day for the next 30 days?
You’ve heard this one before. It’s the fun, sneaky question we ask kids — and sometimes, adults — to make a point about compound interest.
“Interest” tends to be a word we take for granted. It’s what makes money (or debt) grow.
But… what does that mean, exactly? How on earth does it work?
What is Compound Interest?
On the positive side: Interest is what a bank pays you to keep your money there. The longer your money stays in the bank, the more you earn in interest.
“Compound interest” means you get paid interest on interest.
It works like this: An interest payment is added to your balance. When the next interest is calculated, you get paid for that full balance, instead of just the amount you initially contributed.
So your bank is actually paying you to keep the money it already paid you there. Good deal.
Many people, faced with the option above, choose $10,000 now over the pennies with 100% interest.
At that unbelievable rate, after 30 days, your pennies would grow into more than $5.3 million. By day 31, you’d have $10 million! For a contribution of 30 cents.
This level of growth isn’t at all likely, but it helps make the point. Interest makes the world go ‘round.
How Compound Interest Works
How does a penny turn into $5 million in 30 days? We like to call it magic, but it’s really just math.
Start with 1 cent on day one.
On day two, you earn 100% of the balance and add another cent. Now you have 3 cents.
On day three, you earn 100% again and add another cent. Now you have 7 cents — seven times your original balance in just three days.
Your pennies gather interest like a snowball rolling downhill.
That’s how your retirement account grows and why it’s important to start saving early, even if you can only contribute a small amount. With compound interest, your greatest asset is time.
Compound Interest and Debt
Unfortunately, we can’t ignore the negative side of compound interest: paying it.
When you don’t pay bills on time, companies charge interest. Banks also charge interest while you pay back a big loan — now you’re holding their money, and the tables are turned.
You should understand this before taking out your first loan or opening your first credit card.
The more debt you sit on, the more interest will accrue each month, because it’s a percentage of your balance.
In the same way your pennies grew into millions above, your credit card debt can tumble out of control if you lollygag while paying it back.
Imagine if you owed a penny today, how much you could owe in 30 days…
Yikes. There’s a reason we don’t play this game in reverse.
Your Turn: Think you could you explain compound interest to a 5-year-old?
Dana Sitar (@danasitar) is a senior writer at The Penny Hoarder. She’s written for Huffington Post, Entrepreneur.com, Writer’s Digest and more, attempting humor wherever it’s allowed (and sometimes where it’s not).