What is compound interest and how does it work?
Without interest, your money does not grow.
If you keep money in a shoebox at home for a rainy day, your total won’t go up unless you add more to it.
On the other hand, if you borrow $50 from your sister, the amount you owe will not reach $75 when you pay her back, because it is an interest-free loan. (Thanks sister.)
But if you were to keep your savings in a bank account or take out a loan from a payday lender, the outcome would be different. You would see an increase in your savings – or what you owe – due to compound interest.
But what is compound interest and how does it work? We will explain to you.
What is compound interest?
Compound interest is a basic financial concept that explains how your money can grow exponentially. Your balance grows by earning interest on interest.
A little confusing, we know. So let’s break it down with an example.
If you had $1,000 in an account earning 5% interest annually, you would end up with $1,050 at the end of the year. If your interest is compounded, you’ll earn 5% of your $1,050 balance—an extra $52.50—at the end of the second year, leaving you with a total of $1,102.50.
Simple interest, on the other hand, is interest only on the original balance. Your interest income is not taken into account when calculating interest for subsequent years.
If your $1,000 were in a simple interest account at the same 5% annual rate, you would still have $1,050 at the end of the first year. However, at the end of the second year, you will only earn interest on the $1,000 you originally deposited, not the $1,050. You would earn $50 more instead of $52.50, leaving you with a balance of $1,100.
Now an extra $2.50 is no big deal, but let’s say you left that money in your account for 20 years instead of two. With compound interest, you would have $2,653.30 after 20 years. With simple interest, you would only have $2,000.
How to Calculate Compound Interest
Calculating compound interest does not require major mathematical skills.
Although there is a fancy formula for calculating compound interest, we are going to let you in on a secret. You can find a bunch of compound interest calculators online, including this one from the United States Securities and Exchange Commission.
Simply enter your initial investment, how long you plan to save, your interest rate and how often the interest is compounded, and you’re done! Compound interest is calculated for you.
If you’re curious or have a thing for algebraic equations, the formula for compound interest is as follows:
A = the future value you will end up with (both the initial capital and the interest earned)
P = the initial principal amount (what you start with)
r = annual interest rate (in decimal form)
n = number of times interest is compounded in a year
t = time in years
The math involved in calculating compound interest is much easier if you just want to know how many years it would take for your money to double. Using what’s called 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 per year, it would take 12 years for your capital to double to $2,000 (because 72 divided by 6 equals 12).
Additionally, you can use the rule of 72 to determine the interest rate you would need to double your money in a certain number of years. You would calculate this by dividing 72 by the number of years.
For example, for your principal to double in 8 years, you would need an annual interest rate of 9% (because 72 divided by 8 equals 9).
How to get the most out of compound interest
Understanding the factors that affect your money’s growth can help you harness the power of compound interest.
Get a good interest rate
It’s pretty obvious that the higher the interest rate you get, the higher your returns. But how do you get the best interest rate?
If you’re putting money into a savings account, look for a high-yield savings account, which exceeds the national average of 0.06% interest. Online banks often offer better rates because they don’t have the overhead that brick-and-mortar banks have. This does not mean, however, that traditional banks do not offer competitive rates.
Here are the 5 best high-yield savings accounts we’ve found.
Money market account interest rates can rival some high-yield savings accounts, so this is another option.
If you open a certificate of deposit (or CD), the interest rate is generally higher when you choose a longer term. But make sure you’re okay with not touching your money for that long. You are charged a fee for withdrawing money from a CD before its maturity date.
If you invest 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 of between 6% and 10% when investing for the long term. However, the stock market is volatile and carries more risk.
Maximize the time you earn compound interest
The longer you let your savings sit, the more compound interest can work in your interest (pun intended).
If you put $1,000 in an account that pays 5% interest, compounded annually, at age 25, that money will grow to $7,039.99 by the time you turn 65. If you saved the same amount at the same rate starting at age 35, you would have $4,321.94 at age 65. If you waited until you were 45, you would only have $2,653.30 at age 65.
Make compound interest work better in your favor by allowing more time for accrued interest to grow.
Keep adding to your savings balance
It can be tempting to deposit money once in an interest-bearing savings account and let the magic of compound interest do its job. But you’ll get more out of it — a plot more — if you regularly increase your savings.
Remember the $1,000 in the previous example that grew to $2,653.30 after 20 years?
Let’s say you only had half that amount to start with, but you made a commitment to deposit $10 into your account each month. That money, earning interest on your initial capital of $500 plus the $10 you invest month after month, for 20 years, would total $5,294.56.
By making the monthly deposits of $10, you will have invested $2,900 of your own money over 20 years and earned $2,394.56 in interest. When you initially save $1,000 and make no additional contributions, you only earn $1,653.30 in interest.
So keep putting money aside, even a little at a time.
Consider the frequency of the compounding period
The frequency of interest calculation also plays an important role in how much you can save. More frequent compounding leads to greater savings growth.
Our previous examples were based on compound interest once a year. However, interest may be compounded at other regular frequencies, such as monthly or daily.
Capitalization frequency can also be discussed in terms of capitalization periods. If interest is compounded monthly, you would have 12 calculation periods per year. If compounded daily, you would have 365 compounding periods per year.
Using the same example of $1,000 in an account earning 5% interest, here’s what you’d get after 20 years at different compounding frequencies.
The more the interest is compounded, the more your savings will increase.
And just because your bank only deposits your interest earnings into your account once a month doesn’t mean the interest is compounded monthly. Many financial institutions that accrue interest daily wait until the end of your monthly statement period to add this income.
Another important note: when you come across interest rates advertised by a financial institution or lender, the APY (or annual percentage yield) takes into account the frequency of compounding, unlike the APR (annual percentage rate). ).
You’ll want to watch out for APY when it comes to accounts where you earn compound interest, like a savings account or CD.
How does compound interest work against you?
While compound interest can be a great source of savings, it’s not all rainbows and roses. Compound interest is also the reason you never seem to have your head above your credit card debt while making minimum payments.
Just as your savings balance increases when interest is compounded, so does your 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 will be added to your balance. You will then be charged interest based on your new balance – the original amount plus accrued interest (minus any payments you have made).
Compound interest can really hurt you with negative amortization. This is when your monthly payment is less than the interest accrued over that period and your outstanding balance is increasing instead of decreasing.
When taking out a loan or opening a new credit card, here are four things to keep in mind:
Get the lowest interest rate possible. — Raising your credit score will usually result in lenders offering you lower interest rates.
Keep your loan period short. — You will pay less interest with a three-year car loan than with a five-year loan.
Pay more than the minimum. – If you dig into your credit card statements, you’ll see a section that details how long it would take to pay off your balance if you only made minimum payments and how much interest you’d pay compared to what it would take to pay off your balance in three years and how much you would save.
Make payments every two weeks. — You’ll end up putting more money in your principal balance and paying less interest by making payments on your debt every two weeks rather than once a month.
Not all lenders accrue the interest they charge. Interest calculated for a mortgage, car loan, or federal student loan will generally be simple interest – interest based only on the original principal amount of the loan.
Nicole Dow is a senior writer at The Penny Hoarder.
This was originally published on The Penny Hoarder, which helps millions of readers around the world earn and save money by sharing unique job opportunities, personal stories, giveaways and more. The Inc. 5000 ranked The Penny Hoarder as the fastest growing private media company in the United States in 2017.