When investing, you should take advantage of compound interest. But just what is compound interest?
It goes like this. When you have a savings account, you accrue periodic interest, which is usually paid out monthly (the month is the period). The interest you earn is added to your account balance. The next month, you’re paid interest on the original balance and the interest that was added to that balance the previous month.
In other words, you earn interest on the new balance, which now includes the interest you earned last month. This increase is described as compound interest. It compounds month to month.
In addition to its investment advantages, compound interest can also have a negative impact when applied to borrowed money, such as loans or credit cards that you have to pay back.
Understanding the power of compound interest is key to investment—and even borrowing—success.
Terms to Understand
Although you may know that compound interest is financially beneficial, calculating the exact amount your accounts earn can be challenging. To do this effectively, you need to understand a few common terms.
Compounding frequency is the interval at which your interest is paid out. Accounts that pay interest more often—say monthly compared to annually—see the greatest increase from compound interest.
Most types of accounts stick to a standard compounding schedule. For example, bank savings and money market accounts usually compound interest daily. CDs pay interest that’s compounded daily, compounded monthly, compounded annually or even compounded several times a year. Sometimes interest is compounded daily but only added once a month.
Once the interest is added to your account, the compounding period begins and interest starts to accrue on your new balance.
Annual equivalent rate is the amount of interest that’s payable in one year, divided by the principal (the original balance) amount. Banks must provide the annual equivalent rate used so that consumers can compare it to the nominal annual interest rate. The nominal rate is the advertised rate for a financial product and doesn’t include fees or compounding interest.
Simple interest is the term used for interest that doesn’t earn interest. Interest accrues on your principal balance each month but isn’t added to the balance, so you earn less than you can with compounding interest.
Calculating Compound Interest
The formula to calculate compound interest is [P (1 + i)n] – P. In this compound interest formula, the variables are as follows:
- P represents the total balance of your investment account.
- i is the nominal annual interest rate, expressed as a percentage.
- n is the number of compounding periods. For example, if you’re calculating the annual compound interest for an account that pays interest monthly, n would equal 12.
Let’s look at an example. Imagine you want to calculate the annual compound interest you’ll earn on a savings account with a balance of $10,000 (P). The account has a nominal annual interest rate of 2% (i) and pays interest quarterly (n=4).
The equation looks like this: [10,000 (1+.02)4] –10,000. When calculated, you’ll earn about $824.32 in compound interest on this account in a year.
You don’t actually need to do the math yourself. Your bank or savings account provider will do that.
You can also easily figure out your compound interest earnings using the free compound interest calculator provided by the U.S. Securities and Exchange Commission. Simply enter your account balance, the nominal interest rate and the number of compounding periods. Then, click the calculate button for your results.
Why Compound Interest Matters
Compound interest can create a significant return on your initial investment. However, the true magic of compound interest is even more obvious when you look at how your investment grows exponentially over several years.
Let’s revisit the example above. Instead of looking at just one year, let’s look at 10 years by changing n=4 to n=40—the number of quarterly compounding occurrences over the decade. Our new equation looks like this:
[10,000 (1+.02)40] –10,000
Solved, you see that you have $12,080.40 in compound interest over 10 years from your initial $10,000 investment—that’s an additional 2,080.40. The table below shows the amount of compound interest earned by this account at 1, 10 and 25 years.
|Year 1||Year 10||Year 25|
And those earnings are without any added principal. Your money is just sitting and making more money.
In comparison, an account that pays only simple interest would continue to accrue interest only on the original $10,000, not on the added interest. You would earn just $2,000 in interest over 10 years.
You can use compound interest to grow retirement accounts and other accounts—say for a new car or a down payment on a home loan—by investing money when you’re young and taking full advantage of compound interest over time. The longer your money compounds interest before you take it out, the more money you’ll have.
Some finance experts use the Law of 72 to estimate how long it will take to double your money with an investment and compound interest. To see for yourself, divide 72 by the account’s annual interest rate. In the example above, divide 72 (the total at year 25) by 2, which means it will take 36 years to double your $10,000 at a 2% annual interest rate. If you chose an account that pays 6% interest, you can double your money in just 9 years.
Making Compound Interest Work for You
Now that you know how compound interest works, you can take advantage of strategies to use it to maximize your investment. Try these tips to help your money grow to its full potential:
- Save as much as you can afford to save as soon as you can afford to. Remember, the more times you allow your interest to compound, the more valuable your investment is. Also, avoid withdrawing funds from these accounts unless you absolutely have to.
- Look at the annual percentage yield (APY), not the annual percentage rate (APR), when comparing accounts. The APY is usually higher and offers a more accurate picture of the expected interest you’ll earn.
- Choose accounts that compound interest daily, rather than monthly, quarterly or annually. Some accounts even offer continuously compounding interest, but the earnings are usually similar to those offered by daily compounding accounts.
If you’re looking for a high-interest savings account with a good interest rate, you can find some right here on Credit.com.
Paying Compound Interest
Understanding compound interest also helps you understand the true cost of money you borrow. This concept explains why the balance on your student loan or credit card account increases over time, even if you don’t borrow more money. You can avoid the negative effects of compound interest by paying more than the minimum monthly payment on your debts whenever you can.
Let’s say you have a credit card account with a $5,000 balance and a 20% APR. Assume you only make the minimum payment and continue to carry a balance of around $5,000. The first year, you’ll be charged $1,000 in interest. The second year, your balance will be about $6,000, and you’ll be charged $1,200 in interest. The third year, the 20% would apply to your now $7,200 balance for an annual interest charge of $1,440.
You can see why it’s so important to avoid carrying a high credit card balance and to paying it down as much as you can each month. It also shows why a credit card with a low APR is valuable if you can qualify for one. In fact, if you pay off your full balance each month, you can completely avoid paying interest on credit card purchases.
Mortgages actually don’t charge compound interest. With a mortgage, the interest you pay is determined at the start of the loan. What you pay is spread out over the life of the loan via the amortization table. But you don’t pay interest on top of interest not yet paid with a home loan. Mortgages use simple interest and not compounding interest.
Start Taking Advantage of Compound Interest Today
When you’re ready to begin exploring the advantages of compound interest, Credit.com makes it easy to compare interest rates, fees and features of savings accounts so you can find the perfect way to watch your money grow. You can also check your credit score—for free—and learn how to boost your number so that you can qualify for low-interest loans and credit cards.
Happy saving and smart spending.