Compound interest is a way to make your savings grow faster. This concept means you earn interest not only on the initial principal amount invested (usually in a savings account) but also on the interest you’ve earned in previous periods.
Yep, you’ll earn interest on the interest you’ve already earned – it compounds!
Unfortunately, this personal finance concept can also apply to student loans and credit card loans. That means the total interest you owe on the money you borrow will grow faster; it’s easier to get stuck in debt when interest compounds.
So what is compound interest exactly, how does it work, and what’s the compound interest formula? We’ll answer all these questions and more below.
Compound interest definition
Put simply, compound interest is the interest you earn on your interest. It considers your starting balance and accumulated interest to determine your final balance. Compound interest may also be referred to as compounding interest.
Compound interest can be both good and bad. It’s good when you’re earning money on your balance. This is often the case for savings accounts or other investment accounts where you make a large deposit and earn interest on how much is in your account.
It can be bad when you have a loan or other debt with compounding interest. The balance you have to pay back grows more quickly, forcing you to pay more money the longer you have the debt. You may see this with student loans, personal loans, mortgages, and credit cards.
How does compound interest work?
Compound interest works by calculating interest on your starting balance and the interest you’ve earned in previous periods. Say you start with $1,000 in your bank account (the initial principal) with a 5% annual compounding interest rate. After one year, your balance is $1,050. After two years, your balance is $1,102.50. How did this happen?
- Year one: $1,000 (starting balance) + $50 (5% interest on starting balance) = $1,050
- Year two: $1,050 (starting balance) + $52.50 (5% interest on balance including year one interest) = $1,102.50
In addition to earning $50 each year to keep a balance of $1,000, you also earn interest on your interest. So, you earned $50 from your first year of interest, $50 for the second year of interest, and $2.50 of interest on your interest. If the interest were not compounded, you would have earned just $50 the first year and $50 the second year.
Compound interest formula
How do you calculate compound interest? Here’s what the formula looks like:
A = P * (1 + r/n)nt
A refers to the total amount at the end of the investment period. On the other side of the equal sign, here’s what all those symbols mean:
- P (principal amount): The amount you invest initially, such as the starting balance of a high-yield savings account.
- r (interest rate): This is the interest rate on the account, expressed as a decimal. For instance, a 5% interest rate would appear in the compound interest formula as 0.05.
- n (number of times interest is applied): The compounding frequency refers to how often interest is compounded. For many accounts, it’s annual – that’s once a year. Some accounts may compound twice a year, quarterly, or even monthly. The higher the number of compounding periods, the more interest you stand to earn.
- t (total time): This should be expressed in years and refers to the length of time that money will be invested.
When calculating compound interest to determine the future value of your investment or savings, you need to know the compound period. The compounding period is the time between when the interest was last compounded and when it will be compounded again. In other words, it’s how often you earn interest. Compounding interest periods are often yearly.
The rule of 72
Want to know how long it will take you to double your money with compound interest? Just use the rule of 72.
With this rule, you simply divide the number 72 by the compound interest rate you’ll earn in an account. The result of the calculation is the number of years it will take to double your investment.
For instance, a 5% interest rate would take 14.4 years to double the investment: 72/5 = 14.4 years.
This formula is specifically helpful for compound interest that compounds annually. If you have continuous compounding interest, you should use the number 69.3.
Compound interest vs. simple interest
Compound interest is different from simple interest because it considers accumulated interest. With simple interest, you can only earn interest on your original balance. So if your balance stays the same for five years straight, you’ll earn the same amount of interest each year, no more. With compounded interest, you’d earn more each year.
Check out this table for some key takeaways on compound vs. simple interest.
If it’s a savings or investment account, compound interest can help you make more money. If it’s a loan or other debt, simple interest is often better to ensure you have predictable payments and don’t end up paying more in the long run.
Pros and cons of compound interest
Compound interest can be to your advantage when investing money, but when borrowing, you can quickly find yourself owing more money back to lenders if the interest compounds. Let’s break down the pros and cons of compound interest.
- More money: With compound interest, you’ll grow your savings or investments faster than with simple interest.
- Snowball effect: The longer you invest your money, the more substantial the total interest earnings become. Over a long period of time, you stand to earn more money from compound interest.
- Automatic: If you put your money in a savings account with compound interest, it’ll accrue automatically. You don’t need to do anything to earn it other than keep your money in the account.
- Wealth erosion: “Wealth erosion” happens when the cost of living increases but the amount of money you have does not. With compound interest, your money is more likely to keep up with inflation.
- Debt: Compound interest is great when you’re saving or investing – but if interest is compounded on a loan that you have, it has the opposite effect. The interest you owe will accrue faster, and you’ll owe more money in the long term. And if you only make the minimum payment required on credit card debt, you may find that the debt balance continues to grow, even as you pay your credit card bill.
- Confusing: Compound interest can be confusing – and the compound interest formula is harder to use if you’re withdrawing or depositing more money over time on top of the initial principal amount.
- Timeline: It can take several years for real growth to kick in from compound interest. That means you’ll need to set money aside in savings and let it grow on its own. Withdrawing money will slow the pace at which the investment grows.
- Taxes: Earning interest is great, but Uncle Sam thinks so, too. You’ll owe income taxes on all interest you accrue.
Investing with compound interest
We often think of compound interest for our savings account, but you can also use compounding interest as an investor.
For instance, you can have your financial advisor or brokerage firm reinvest your dividends by purchasing more shares of the asset that produced the dividends. Then, you’ll stand to earn more interest payments (and dividends) from that asset.
Here are some investment vehicles that pay compound interest:
- Certificates of deposit (CDs)
- Real estate investment trusts (REITs)
- Mutual funds
Making the most of compound interest
If you have a deposit account with compounding interest, here are some steps you can take to make the most of your money:
- Start saving early
- Create an interest-earning emergency fund
- Deposit money when you can
- Pay attention to compounding periods
- Avoid emptying your account
- Go for accounts with the highest interest rates
Interest can be a helpful savings tool. If you already have money in a savings account, why not find one that rewards you for keeping that money tucked away?
Take an interest in compound interest
Figuring out interest can seem daunting. But it doesn’t have to be! Take your time to learn about the different types of interest rates so you feel confident in your financial choices. Explore ways to make the most of your money, like how to earn interest on the money you already have.
Want to increase your personal finance knowledge even more? Learn the difference between APR and interest rate.
Compound interest FAQs
Is compound interest good or bad?
Compound interest is good for savings and other investment accounts where you’re earning money back into your pocket. Compound interest can be bad for loans and other debts, which means you’re paying back interest that keeps accumulating.
What’s an easy definition for compound interest?
Compound interest means you earn interest on your interest. This is different from simple interest, which means you only get interest back on your starting balance.
What’s an example of compound interest?
If you have $100 in your savings account with an interest rate of 5%, you’ll have $105 at the end of the first year. At the end of the second year, you’ll have $110.25. The extra $0.25 comes from earning 5% interest on the $5 interest you made your first year.
Who benefits from compound interest?
People who can invest money in a savings account, certificate of deposit, bond, or other form of investment can benefit from compound interest. The longer they leave the money in the account, the more money they stand to earn over time.
How can I tell if interest is compounded?
Banks, credit unions, and financial institutions typically advertise how their interest is calculated. This may be in the fine print. If you already have an account, check your most recent bank statement to see how interest is calculated. When in doubt, speak to the customer service of the bank or credit union where the account is held.