You might have heard people use the term compound interest, but if you can’t answer the question “What is compound interest?” then you’re missing out on how compound interest affects your finances. The simple definition of compound interest is that it is interest paid on both the principal and accrued interest.
Check out this detailed breakdown of compound interest so you can better see how compounding can benefit — and hurt — your finances.
What Is Compound Interest?
So, exactly how does compound interest work? Compound interest is the interest paid on the initial principal, or account balance, as well as the amount of interest that accumulates. Compound interest can be earned on savings accounts and retirement accounts. It can also affect some debts and loans, causing you to pay more for your loan over time.
Compound Interest vs. Simple Interest
There are two types of interest, simple interest and compound interest. What is simple interest? According to the simple interest definition, it’s interest paid on the principal capital only.
When it comes to compound interest versus simple interest, compound interest is a better choice for financial investments and savings accounts. An account with continuous compounding interest will earn more money for you than an account that accrues only simple interest. In other words, the power of compound interest can allow your investment to grow faster than simple interest can.
Take a look at these examples of compound interest to see how much more compound interest earns over simple interest accounts:
If you invest $10,000 for five years at 5 percent per year, with interest paid at the end of the term, you’ll earn $500 each year in simple interest, or $2,500 after five years. At the end of that five-year term, you would have $12,500.
If you invested the same $10,000 in a compound interest account for five years at 5 percent, with interest calculated and added monthly, you’d earn $2,834 in compound interest after five years, giving you a total of $12,834. A compound interest investment earns more because you earn interest on both the principal amount as well as the interest accrued.
How to Calculate Compound Interest
Calculating compound interest can be easy if you use an online calculator or manually apply the formula for compound interest. To figure out how to calculate compound interest, use the following formula:
A = P (1 + r/n)(nt)
- A = the amount of money accumulated after n years, including interest accrued
- P = principal amount
- r = the annual rate of interest, which should be a decimal
- n = the number of times the interest is compounded per year
- t = time and is the number of years the principal is deposited or borrowed
For example, say you have $5,000 in a savings account that earns 10 percent, compounded yearly. To find how much your savings will be worth in five years, plug in the numbers to the formula:
- A = P (1 + r/n)(nt)
- A = 5,000 (1 +.10/1)^(1(5))
- A = 5,000 (1.1)^5
- A = 5,000 (1.61051)
- A = $8,052.55
If you wish to calculate only the amount of compound interest, use the same formula and subtract the principal amount. Therefore, the compound interest of the above example would be $3,052.55, because the original principal amount of $5,000 is subtracted from the calculation.
Pros and Cons of Compound Interest
Compound interest works better with more time — this goes for both savings and debts alike. 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 their 30s or 40s will have to save more and will earn less interest.
On the flip side, compound interest problems arise when you’re paying compound interest on a debt. The longer you hang on to such a debt — like credit card debt, for example — the more money you’ll end up owing. So if you’re only making the minimum payment due on a credit card balance, it can feel like the balance never decreases.
Find Out: How to Save Your First $100,000
When you’re trying to figure out how and when to invest your money, consider how powerful compounding frequency can be on your savings. A savings account with a high interest rate that is compounded monthly will earn more money than a simple interest account that pays at the end of the term.