How does compound interest work?
You’ve probably heard of compound interest, but you may not know how it works, as well as how it can both work for and against you.
Interest is essentially the cost of borrowing. When you borrow money, the interest is what you must pay back on top of the original amount borrowed, called the principal. Compound interest is a type of interest that has a snowball effect. After the principal earns interest, both the principal and interest are added together into a new principal, which then earns interest. So, compound interest basically earns interest on interest.
How does it work in your favor? In the simplest terms, compound interest means you can earn more money from savings faster. On the flip side, when it comes to money you borrow, compound interest can work against you by making borrowing more expensive. And debt can be harder to pay off as interest increases.
The concept of compound interest can have a big impact on your financial wellbeing. Understanding how compound interest works and how it’s calculated are important for making sure you’re using it to your advantage rather than having it work against you.
Here, we’ll walk through the ways compound interest can affect your finances—and how to make it work in your favor.
Compound interest vs. simple interest
Interest is an equation that can be calculated in two ways—compound interest and simple interest. Simple interest only uses the original principal amount to gather interest. Compound interest uses the original principal plus previously earned interest to gather the interest.
Let’s look at a quick example of each interest type. Say you have an investment worth $100. At the end of every year, your $100 investment gains 5% interest, which is $5.
With simple interest, you’ll have a total of $105 after year one. After year two, you’ll have a total of $110, and after year three, you’ll have a total of $115. See the pattern? The total amount grows by $5 every year.
Now let's look at compound interest using the same example of $100 with a 5% annual interest rate. At the end of year one, the total is $105 again.
However, compound interest will now use the $105 as the amount drawing interest, instead of just $100. After year two, you’ll have a total of $110.25, and after year three you’ll have a total of $115.76.
As you can see, compound interest builds faster than simple interest. That’s because the principal amount that draws interest grows every year. Although a few cents might not seem like much of a difference, imagine compound interest spread out over many years—and with a much higher principal than $100. It starts to add up faster than you’d think.
Frequency of compound interest
Understanding the frequency of compound interest is important, as a higher number of compounding periods leads to greater compound interest. In the example above, we used an annual interest rate. That means the frequency schedule for the interest is one year.
However, not all interest rates have an annual frequency schedule. Aside from annually, interest can grow by the day, the week or the month. And different loans and lenders all use different compounding frequencies.
A savings account at a bank might have a daily compounding frequency, while the interest on home mortgage loans usually feature monthly compounding frequencies. CD (Certificate of Deposit) accounts can be compounded daily, monthly, or every 6 months. Credit cards can be compounded monthly, and sometimes even daily.
When investing, a higher frequency of compounding can be a big advantage. But, if you’re taking out a loan, it can be a disadvantage. That’s why before borrowing any money, it’s important to understand the ins and outs of how the interest will work.
Making use of compound interest
Compound interest grows larger and larger over time. This simple fact can work with you or against you, depending on the situation. If you’re looking for a long-term investment, compound interest is your friend. But, if you owe someone else money, compound interest can make it harder to pay off your debt.
Savings accounts and CD accounts have their own interest rates. If you’re looking for a place to park your money, ask about the type of interest that’s offered and the frequency of the interest.
The interest you pay on credit card and other loans can be looked at as a percentage you pay the bank or institution for the privilege of using their money for your own use. Because compounding can work against you in that situation, credit cards and other loans should be paid off as fast and as early as possible. A good rule to keep in mind is the longer you wait to pay off your debt, the more you will usually have to pay.
As with any time you borrow money, it’s important to shop around and look for loans that only charge simple interest. Luckily, significant loans like auto loans or mortgages use simple interest. Other types of loans and credit cards use compound interest, which is why you should always look for the one that makes the most financial sense.
Online tools to help you calculate compound interest
Calculating compound interest can be tricky, especially if number crunching isn’t your strength. Thankfully, you don’t have to do it alone, as there are plenty of compound interest calculators online, and you can use most of them for free.
Investor.gov offers an easy compound interest calculator that’s laid out in simple steps to help you enter the numbers in the right places.
Calculator.net also has an interest calculator with many options for calculating interest rates. The website also features a different kind of compound interest calculator that outlines the difference between simple interest and compound interest over a span of time.
These calculators can come in handy when making regular deposits or payments given that your balance will be in flux over time.
Take some time to consider the role that compound interest plays in your financial planning. The main thing to remember is compound interest and simple interest are different kinds of interest. Over time, compound interest will grow larger than simple interest—even if principals and interest rates start out the same in both situations.
When saving or investing, try to go with accounts that offer compounding interest, and do your best to keep as much money in these accounts as you can so that the interest can grow and make you more money over time.
It can take time to make compound interest work for you rather than against you. But, when done smartly, it can be worth it in the long run when it comes to building a healthy financial future.
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