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Compound interest is a type of interest that takes two things into account when it comes to your money: the principal balance and accumulated interest. This can help you earn more money on deposits or investments. But, watch out for compounding interest on debts. Read on for a deeper understanding.
Compound Interest Definition
Put simply, compound interest is the interest you earn on your interest. It takes both your starting balance and accumulated interest into account 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 type of debt with compounding interest. The balance you have to pay back is then growing, 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 taking your starting balance and how much interest you’ve earned so far. Say you have $100 in your bank account with a 5% annual interest rate. After 1 year, your balance is $105. After 2 years, your balance is $110.25. How did this happen?
- Year 1: $100 (starting balance) + $5 (5% interest on starting balance) = $105
- Year 2: $105 (starting balance) + $5.25 (5% interest on balance including year 1 interest) = $110.25
In addition to earning $5 each year for keeping a balance of $100, you also started to earn interest on your interest. So you earned $5 of year 1 interest, $5 of year 2 interest and $0.25 of interest on your interest. If the interest was compounded, you would have earned just $5 the first year and just $5 the second year.
Compound Interest Equation
For a technical look at compound interest, here’s what the equation looks like:
A: Final balance
P: Principal amount
r: Interest rate
n: Number of times interest is applied per period
t: Number of periods
When calculating compound interest, you’ll need to understand the compound period. The compounding period is the amount of 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. To figure out what your compound interest might look like, consider using a compound interest calculator.
Compound Interest vs. Simple Interest
Compound interest is different from simple interest because it takes accumulated interest into account. With simple interest, you can only earn interest on your original balance. So if your balance stays the same for 5 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.
|Compound Interest||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.
Making the Most of Compound Interest
If you have a deposit account with compounding interest, here are some things you can do 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 great savings tool. If you already have money in a savings account, why not find one that rewards you for keeping that money tucked away?
Compound Interest FAQs
Get answers to questions you still have about compound interest.
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 on loans and other debts where it 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.
Final Thoughts on 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. With the right tools and habits, you’re on your way to a bright financial future.