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Compound interest is an important financial concept that plays a pivotal role in both your investments and your debts. Understanding how compound interest works can help you make more money over time—or pay more in interest if you're not careful.
What Does "Compound Interest" Mean?
Compound interest, or compounding interest, is essentially interest earned on other interest. Each time you add interest to a principal amount, whether on an investment or a loan, that interest—plus the principal—will earn more interest during the next period.
The tricky thing about compounding interest is that it can be both good and bad. It's great when interest compounds on an investment and allows your initial contribution to grow more quickly. But when compounding interest is added to a loan or credit card debt, it's not so great because that's now extra money you have to pay back.
What Is the Difference Between Simple and Compound Interest?
Simple interest and compound interest are earned in different ways. Simple interest is the base interest you earn or accrue on the principal amount you invest or borrow, and it does not compound. It's rarely used in investments and loans. Here's an example:
- Imagine you invest $100 and earn 5% interest on your investment in one year. The interest earned in this scenario would be $5. This $5 is an example of simple interest.
Compound interest is the extra interest you earn on the simple interest that you've already earned. Here is a continuation of the example above:
- Once you add your simple interest ($5) to your principal ($100), you end up with $105. And then let's assume over the next year, you earn another 5% interest—but now it's on your $105, which would net you an extra $5.25 in that year. The extra interest earned ($.25) is the compound interest.
How Do You Calculate Compound Interest?
To calculate compound interest, you need to know a few things:
- What is the total principal that will earn interest? In the scenario above, this is $100.
- What is your interest rate? In the example above, the annual percentage rate is 5%.
- How often does your interest compound? Compounding can happen once a month or once a year, and knowing how often it happens is key to calculating your compound interest. In the scenario above, it is once a year.
- How long will your interest be compounding? This figure represents the number of months or years that you plan to allow interest to compound and grow. This time period may change, based on whether you adjust the term of your loan or whether you decide to hold an investment for a different length of time.
Once you have answers to all the questions above, you'll be able to calculate compound interest for your situation. You can follow the calculation model used above, but in situations where your interest compounds each month rather than annually, you'll have to adjust to account for that.
Here is an example formula you can use to find out how much your interest will compound over a period of time with different compound rates:
Here is what the components of this equation stand for:
- A = The amount of money you will have after a certain number of years
- P = How much you first invested or owed
- r = Interest rate expressed as a decimal
- n = The number of times your interest compounds each year
- t = The number of years the money grows
While this formula may seem complicated, manually accounting for how often your interest compounds and how long it will accumulate would involve you stringing together many smaller equations to get the same answer. For a reliable compound interest calculator, check out this tool.
Can Your Credit Be Affected by Compound Interest?
Compound interest does not directly affect your credit scores. However, missing a bill payment or paying late does. If you have a lot of revolving credit card debt, compounding interest could catch you by surprise and over time make your bill larger than you expected. And if this causes you to pay your bill late, your credit scores could be impacted.
Interest will only begin to compound on an account when you're not paying a sufficient amount to both the interest and principal each month. This could easily happen if you pay just the minimum on your credit cards each month. That's why you should always attempt to pay off your balance in full each month. Doing so prevents any interest from accruing.
Your credit scores are also influenced by your credit utilization ratio, which is calculated by dividing your total revolving credit balances by the total of all your credit limits. If you're consistently paying just the minimum each month and using a lot of your available credit, your credit utilization ratio is likely high, which can negatively affect your credit scores.
To find out more about your credit card balances, and to see what is affecting your credit scores, consider getting a free copy of your credit report and credit scores from Experian to see what's currently showing in your credit file.