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Compound interest is an important financial concept that plays a pivotal role in both your investments and your debts. Simply put, compound interest is interest that accrues on your principal and interest. Put simply, that means the interest you earn is earning interest on itself, which can dramatically impact your balance over time.
Understanding how compound interest works can help you make more money over time—or pay more in interest if you're not careful.
Compound Interest Definition
Compound interest is the interest you earn from your principal savings or investment amount plus any interest the investment earns. Consequently, your account earns interest on top of interest.
Compound interest is important because it enables your money to grow exponentially. Whereas simple interest only allows you to earn interest on your initial investment, compound interest triggers a faster growth rate since you earn interest on your original balance plus your accrued interest. The result is a snowball effect, as your balance gains momentum and produces more significant returns.
The tricky thing about compounding interest is that it can be good or bad depending upon which side you're on. If you're an investor, compound interest helps your investment grow faster; if you're a borrower, compound interest makes borrowing more expensive.
How Does Compound Interest Work?
Compound interest is the extra interest you earn on the interest that you've already earned. Even if you make no additional deposits, compound interest will apply to your balance and your previously earned interest. In this way, compound interest works to build exponentially over time.
Say you invest $10,000 in an investment earning 10% a year in interest. After one year, your account would grow to $11,000—your original $10,000 deposit plus the $1,000 in interest applied to your account. In the second year, your interest compounds to $12,100. In other words, you're earning interest on top of your principal and previously earned interest ($11,000). In this way, your money compounds exponentially over time.
Accounts that apply compound interest grow significantly faster than those that use simple interest. That's because simple interest accrues only on the principal amount you invest or borrow. Simple interest doesn't compound, and therefore only earns interest on your principal balance.
The following chart compares the exponential growth of compounding interest with simple interest.
|Compounding Interest vs. Simple Interest ($10,000 Initial Deposit)|
|Period||Compound Interest (Compounded Annually)||Simple Interest|
As you can see, the compounding interest on your initial deposit grows exponentially and ultimately becomes larger than your principal.
How to Calculate Compound Interest
The massive growth resulting from compound interest can seem magical, but in reality, it all boils down to a simple mathematical formula.
Compound Interest Formula
Here is the formula to calculate compound interest over a specific period.
That formula can look complex at first glance, but let's break it down into its components so you can plug in your numbers to find out how much your interest will compound over a period of time.
Here is what the components of this equation stand for:
- A = The final amount of money you will have at the end of the time period
- P = Your principal, or how much you first invested or owed
- r = Interest rate expressed as a decimal. For example, if your interest rate is 4% per year, you would enter 0.04 into the formula here.
- n = The number of times your interest compounds each year
- t = The number of years the money grows
Calculating Compound Interest Example
Let's say you deposit $10,000 with a 10% annual interest rate and you leave the money untouched for 10 years, you'd earn $25,937.42 based on the following calculation.
$10,000 × (1 + 0.10/1)^(1 × 10) = $25,937.42
The same investment results in a higher final amount when the interest compounds monthly (12 × 10 years) rather than annually.
$10,000 × (1 + 0.10/12)^(12 × 10) = $27,070.41
Once again, the same investment produces a higher return when the interest is compounded daily (365 × 10 years).
$10,000 × (1 + 0.10/365)^(365 × 10) = $27,179.10
Understanding how compound interest is calculated is valuable, but if you'd rather not do the math yourself, you can always use a compound interest calculator.
How to Take Advantage of Compound Interest
The accelerated growth from compound interest can generate passive income you don't have to work for. Consider the following strategies to maximize your gains through compounding interest.
- Start saving early. The longer you invest your money, the more opportunity it has to compound and grow.
- Leave your investments untouched. Withdrawing money reduces your principal and, consequently, your returns. Instead of pulling out money, reinvest your earnings back into your investment account to boost your potential earnings.
- Consistently contribute to your account. The more money you add to your investment account, the more you can build wealth over time through the power of compounding interest.
- Choose the highest-earning investments. Investment accounts that earn interest, like high-yield savings accounts or certificates of deposit (CD), compound interest over time to grow exponentially. For higher potential earnings, it pays to shop and compare investment products to identify the ones with the highest interest rates.
Find High-Yield Savings Accounts
When Is Compound Interest Bad?
As good as it is where your investments are concerned, compound interest can work against you in other areas. For example, when compounding interest is added to a high-interest debt such as a credit card or payday loan, you must repay a higher debt balance.
You won't incur any interest charges if you pay your credit card balance in full by the monthly due date. However, you'll accumulate interest on your remaining balance if you don't pay in full. Generally, credit card interest compounds daily, making it challenging to pay down your debt.
Consider this: If you have a credit card with a $5,000 balance and a 20% interest rate, and you make minimum payments of $100 each month, it will take you seven years and 10 months to zero out your balance. In total, you'd pay $4,311 in interest, which is 86% of your original $5,000 balance.
Can Your Credit Be Affected by Compound Interest?
Compound interest does not directly affect your credit scores, but late payments do. 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. Your payment history is one of several factors that influence your credit score.
Maintaining good credit may help you qualify for lower interest rates on loans and credit cards. Reviewing your credit regularly is a wise practice to get a clearer picture of your credit health. Get a free copy of your credit report and credit score from Experian to assess your credit and identify any areas of improvement.