You might have heard the term “compound interest” thrown around, but if you can’t answer the question “What is compound interest?” then you’re missing out on how this important component affects your finances. Compound interest is interest that’s paid on both the principal and accrued interest, thereby compounding the amount of interest you earn. The time value of money principle states that money now is worth more than the same amount of money in the future because you can earn interest on it.
Keep reading this breakdown to learn about interest and how compounding can benefit — and hurt — your finances.
Compound Interest Definition
How does compound interest work? Compound interest — the interest paid on the initial principal plus the amount of interest that accumulates — can be earned on savings accounts and retirement accounts. On the negative side, compound interest can also affect some debts and loans, causing you to pay more for your loan over time.
Simple Interest Definition
Simple interest is interest paid on the principal capital only. For example, if you buy a bond that pays three percent interest annually and you have that money sent to you directly, you’ll receive that same three percent check every year. You won’t receive any additional compound interest.
When it comes to compound interest vs simple interest, compound interest is a better choice for financial investments and savings accounts, since the power of compound interest can allow your investment to grow faster than simple interest can.
Compound Interest Example
Compound interest accounts will earn more money due to the nature of interest that is compounded continuously. Here’s an example of how much more compound interest earns over a simple interest account.
If you invested $10,000 at 6 percent interest compounded annually, you would earn $600 in the first year, the same as with simple interest ($10,000 times 6 percent equals $600). However, for year two, you’d earn 6 percent on $10,600, which equals $636. By the end of year 20, you’d be earning more than $1,800, all with the same 6 percent annual rate. By contrast, a simple interest account would have earned $600 per year times 20 years, or just $1,200. A compound interest investment earns more because you earn interest on the interest.
How to Calculate Compound Interest?
You can calculate compound interest either using an online calculator or by using the annual compound interest formula, which is:
A = P (1 + r/n)(nt)
In the formula:
- P stands for principal — this can be either the amount in your savings account or your loan amount.
- r stands for the annual rate of interest, which should be a decimal.
- t stands for time and is the number of years the principal is deposited or borrowed for.
- A is the amount of money accumulated after n years, including interest accrued.
- n is the number of times the interest is compounded per year.
- A = P (1 + r/n)(nt)
- A= 5000 (1 +.10/1)^(1(5))
- A= 5000 (1.1)^5
- A= 5000 (1.61051)
- A= 8,052.55
To calculate the compound interest only, use the same formula and subtract the original principal amount. Therefore, the compound interest of the above example would be $3,052.55, because you subtract the original principal amount of $5,000 from the calculation.
If you’d rather just have a rough estimate rather than using a precise formula, follow the “Rule of 72.” If you take the interest rate you earn and divide it into 72, you’ll solve for the number of years it will take to roughly double your money. For example, if you earn 10 percent per year, you will double your money in about 7.2 years, rather than the 10 years you would expect using simple interest (10 years times 10 percent interest per year equals 100 percent earnings, or double).
The Power of Compound Interest
Compound interest works better with more time, and this goes for both savings and debts. Starting a retirement account in your 20s means you can save less, yet have more money after 40 years, whereas someone who starts saving for retirement in his 30s or 40s will have to save more and will have earned less in interest.
Say you want to have $1 million saved by the time you turn age 67. If you start in your 40s, you can reach that goal by putting away $1,300 every month, assuming a 6 percent return on your investments. If you’re in your 30s, you’ll need to sock away $651 a month. If you start in your 20s, it will take just $415 per month to reach that milestone. Compound interest, coupled with time, carry a lot of power when it comes to your investments.
Compound interest can be paid over almost any time frame, such as daily, monthly, quarterly or annually. Many investment returns are reported using the compound annual growth rate, or CAGR. The more rapid the compounding the period, the more interest you earn. If you invest $10,000 for 10 years at 5 percent interest, you’d have the following balances, based on the compounding period:
- Compounded yearly: $16,289
- Compounded quarterly: $16,436
- Compounded monthly: $16,470
- Compounded daily: $16,487
Investments That Pay Compound Interest
One of the most common types of investments that compounds interest is a CD. When you buy a CD, you’ll get quoted both the annual percentage rate and the annual percentage yield. The APR is the nominal interest rate and the APY factors in the effects of compounding.
Learn More: How Much Interest Will I Make on a CD?
Income-oriented mutual funds, such as bond funds, are another type of investment that can benefit from the effects of compound interest. Most funds pay monthly, and if you reinvest the dividends into more shares of the fund, you’ll earn compound interest in every subsequent payment period.
Pros and Cons of Compound Interest
As you now see, compound interest works both ways. Here’s a look at the advantages and disadvantages of compound interest:
- Compound interest grows your money faster.
- Invest at a younger age with less money, and still save more than investors who start later in life.
- Compound interest can turn a lower nominal rate of interest into a high total return over time.
- If you have debt, compound interest grows your debt faster than your loan interest rates.
- You must reinvest your income to enjoy the benefits of compound interest.
- Calculating how much you’re earning with compound interest is more complicated.
Find Out: The Best Interest Rate in Every State
Look at how powerful compounding frequency can be on your savings while deciding how and when to invest or reinvest your money. A savings account with a high-interest rate compounded monthly will earn more money than a simple interest account that pays at the end of the term.