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Compound Interest: How Does It Work

Julian Dossett
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Interest is the cost of borrowing. 

When you borrow money, the interest is what you must pay back on top of the original amount borrowed.

That original amount that was borrowed is called the principal. 

Compound interest is a kind of interest that has a snowball effect. After the principal earns interest, both the principal and interest are added together into a new principal. 

Then this new principal earns interest. 

So, compound interest earns interest on interest.

This concept is powerful, and it can work with you or against you. We’ll walk through the ways compound interest can affect your life—and how to make it your friend.

Compound interest vs simple interest

Interest is an equation. It can be calculated in two ways—compound interest and simple interest.

Simple interest only uses the original principal amount to find the interest.

Compound interest uses the original principal plus previously earned interest to find 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 $110. 

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

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.

Before you take out a loan, make sure you 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. 

Savings accounts and CDs all 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.

If you owe someone else money, compound interest can make it harder to pay off your debt. 

Credit cards and other loans should be paid off fast and early. 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. 

Online tools to help you calculate compound interest

Calculating compound interest can be tricky. Thankfully, you don’t have to do it alone.

There are plenty of compound interest calculators online, and you can use most of them for free.

We recommend the compound interest calculator that’s available from Investor.gov. The calculator is laid out in simple steps to help you enter the numbers in the right places. 

Calculator.net has an interest calculator with many options for calculating interest rates. The website also features a different kind of compound interest calculator that tells you what the difference is between simple interest and compound interest over a span of time.

What’s next?

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. 

If you can make compound interest work for you, your money will grow over time as the interest collects. This takes time. But it’s worth it in the long run!

Opinions, advice, services, or other information or content expressed or contributed here by customers, users, or others, are those of the respective author(s) or contributor(s) and do not necessarily state or reflect those of Varo Bank, N.A. Member FDIC (“Bank”). Bank is not responsible for the accuracy of any content provided by author(s) or contributor(s).

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