Without interest, cash won’t multiply.
If you stash bills in a sock drawer for emergencies, the total remains the same unless you add more funds to it.
Conversely, if you borrow $50 from a sibling, that amount doesn’t balloon to $75 when you repay them if it was an interest-free loan. (Appreciate the help, sibling.)
But if you keep your savings at a bank or take out a loan from a short-term lender, the result changes. Your savings — or what you owe — will grow because of compound interest.
So what exactly is compound interest, and how does it function? We’ll walk you through it.
What Is Compound Interest?
Compound interest is a straightforward financial idea that shows how your funds can expand exponentially by earning interest on previously earned interest.
It sounds a bit tricky, we get it. Let’s clarify with an example.
Suppose you have $1,000 in an account paying 5% interest annually. At year-end you’d have $1,050. If that interest compounds, the next year you’d earn 5% on $1,050 — an extra $52.50 — bringing your total to $1,102.50.
Simple interest, by contrast, only applies interest to the original principal. Your earned interest isn’t included when calculating future interest.
If the $1,000 sat in an account paying simple interest at the same 5% yearly rate, you’d still reach $1,050 after the first year. But at the end of year two, you’d earn interest solely on the initial $1,000, not on the $1,050. You’d get another $50 instead of $52.50, ending the second year with $1,100.
An extra $2.50 might seem insignificant, but imagine leaving the money invested for 20 years. With compound interest you’d end up with $2,653.30 after two decades. With simple interest you’d only have $2,000.
How to Calculate Compound Interest
You don’t need advanced math to figure out compound interest.
There is a formal equation to compute compound interest, but here’s a helpful secret: there are many compound interest calculators online — including this tool from the U.S. Securities and Exchange Commission.
Enter your starting amount, how long you’ll let it sit, the interest rate and how frequently interest compounds, and presto — the compound interest is computed for you.
If you’re curious and enjoy algebra, the compound interest formula looks like this:
A = P(1 + [r/n])^{nt}
A = the future value you’ll receive (initial principal plus earned interest)
P = the starting principal (what you deposit initially)
r = annual interest rate (expressed as a decimal)
n = how many times interest compounds in a year
t = the number of years
It’s often easier to use the rule of 72 when you simply want to know how long it will take your money to double. Divide 72 by the annual interest rate (as a whole number, not a decimal).
For example, if your $1,000 earns 6% annually, dividing 72 by 6 tells you it will take 12 years for your balance to double to $2,000.
You can also use the rule of 72 to determine the interest rate needed to double your money in a set number of years by dividing 72 by that timeframe.
So, to double your principal in 8 years, you’d need an annual return of about 9% (72 divided by 8 equals 9).
How to Make the Most of Compound Interest
Knowing what influences your money’s growth helps you harness the power of compound interest.
Secure a Strong Interest Rate
It’s obvious: the higher the interest rate, the more you’ll earn. But how do you land a top rate?
If you’re placing money in a savings vehicle, search for a high-yield savings account — one that beats the national average of 0.06% interest. Online banks frequently offer superior rates because they have lower operating expenses than branch-based banks. That said, traditional banks sometimes have competitive options as well.
Money market accounts can offer rates comparable to some high-yield savings accounts, so consider them, too.
With a certificate of deposit (CD), longer terms usually deliver higher rates. Just be sure you’re comfortable locking your funds away for the duration, since early withdrawals typically incur penalties.
When you invest in the stock market, returns aren’t technically interest, but the principle is similar. Financial pros often cite average long-term returns between 6% and 10% for stock investments, though the market is volatile and carries higher risk.
Let Time Work for You
The more time your savings have to compound, the more dramatic the growth.
If you deposit $1,000 at age 25 into an account earning 5% annually with yearly compounding, that balance could reach $7,039.99 by age 65. If you make the same deposit at age 35, you’d have $4,321.94 by 65. Waiting until 45 would leave you with only $2,653.30 at 65.
Allowing more time for interest to compound makes a huge difference.
Keep Adding to Your Savings
It’s tempting to deposit once and rely on compound interest to do the rest. But you’ll see much greater gains if you consistently add to your savings.
Remember the example where $1,000 became $2,653.30 in 20 years?
Now imagine starting with just $500 but committing to putting $10 into the account each month. That initial $500 plus monthly $10 contributions, compounded over 20 years, would grow to $5,294.56.
By making those $10 monthly deposits, you’d have contributed $2,900 over 20 years and earned $2,394.56 in interest. If you’d begun with $1,000 and made no further deposits, you’d have only earned $1,653.30 in interest.
So keep saving, even if it’s modest amounts.
Also consider teaching kids about savings growth with resources like compound interest for kids to help them build strong habits early.
Pay Attention to Compounding Frequency
How often interest is calculated affects how much your savings increase. More frequent compounding results in larger growth.
Our previous examples assumed annual compounding. Interest can also compound monthly or daily, among other schedules.
Compounding frequency is often described by the number of compounding periods per year. Monthly compounding equals 12 periods per year; daily compounding equals 365 periods per year.
Using the $1,000 at 5% example over 20 years yields different outcomes depending on compounding frequency:
- Annually: $2,653.30
- Monthly: $2,712.64
- Daily: $2,718.10
The more frequently interest is applied, the more your balance will increase.
Keep in mind: just because your bank posts interest to your account once a month doesn’t necessarily mean interest is compounded monthly. Many banks compute interest daily but add it to your account at the end of the monthly statement cycle.
Another point: advertised rates can be confusing. APY (annual percentage yield) accounts for compounding frequency, while APR (annual percentage rate) does not.
Focus on the APY for accounts where compound interest matters, such as savings accounts or CDs.
When Compound Interest Works Against You
Compound interest is powerful, but it isn’t always beneficial. It’s also the reason credit card balances can feel like they never shrink when you only make the minimum payment.
Just as your savings grow via compounding, so can the balance you owe.
When you use a credit card or borrow via a personal loan, interest accrues and is added to your outstanding balance. Future interest is then calculated on that increased balance — the original amount plus previously accrued interest (less any payments you’ve made).
Compound interest can be particularly damaging during negative amortization, which occurs when your payment is less than the interest that accumulates for that period, causing the balance to rise instead of drop.
When you take out credit, keep these four pointers in mind:
- Get the lowest rate possible. Improving your credit score usually leads to lenders offering lower interest rates.
- Keep the loan term short. You’ll pay less interest with a three-year car loan than with a five-year loan.
- Pay more than the minimum. Your statements often show how long it would take to clear your balance making only minimum payments, and how much interest you would pay compared to paying the balance off faster.
- Make payments biweekly. Paying every two weeks instead of once monthly means you’ll put more toward principal and pay less interest overall.
Not every lender compounds interest. Mortgages, auto loans and many federal student loans typically use simple interest — interest computed on the original principal balance.
Jordan Reed is a senior writer at Savinly.
