If you want to achieve your personal finance goals, you need to not only make money, save money, and invest money but ensure that the money you’re working so hard for ultimately works for you. Interest is how we earn money on our savings and investments, but how this interest is calculated can be the critical difference between whether your money’s growth is stagnated or exponential.
There are two basic ways that interest is calculated: Simple interest and compound interest.
In this article, we’ll focus on compound interest—what it is, why it’s important, how to calculate it, and how to take advantage of compound interest to grow your wealth.
What is compound interest?
There are two ways interest is typically calculated
- Simple interest
- Compound interest
Simple interest is when a set percentage is applied to the principal amount each year. For instance, if you invest $1,000 at 10% for five years, you’ll receive 10% on the original principal, that is, $100, in interest every year for five years. Bonds are a popular choice with investors looking for simple interest.
Compound interest, on the other hand, is earned when you reinvest your earnings. That is, if you were to take that $100 you earned in interest in the first year and add it to the principal in the second year, the amount of interest would be calculated on $1,100 and not the original principal. What you’re doing is earning interest on interest, which can add up significantly over the years. Mutual funds are a popular choice with investors looking for compound interest.
The power of compound interest is in how quickly it can multiply your money. Compounding periods, or the number of times you allow the interest to be compounded, are critical to this accelerated rate. The longer you leave your investment to compound, the higher and faster your money will grow.
How compound interest works
Albert Einstein called compounding the eighth wonder of the world, and Warren Buffett has famously amassed his vast fortune on the back of compound interest. Over an extended period, money being compounded can grow exponentially when interest is earned on years of previous interest earnings. There are, however, a number of elements that factor into compound interest. They are:
1. Initial principal
The initial amount is where it all begins. 5% interest earned on an investment of $10,000 will look very different from 5% interest earned on a $100,000 investment. That said, while the principal amount matters in how much you earn, start from where you are. You don’t need a large amount of money to benefit from the principles of compound interest.
2. Interest rate
The annual interest rate you earn on your money significantly impacts how much it will grow. If you’re earning 1-2% in a savings account, that money will grow far slower than if you were earning 5% or 10% on that same money. For one, you’d be making more in initial interest, but when you start earning interest on that interest, the higher the number, the more quickly it will compound.
3. Frequency of compounding
Interest is compounded on a given frequency schedule. For some investments, compounding frequency is daily; for others, it can be monthly or annually. The compounding schedule for savings accounts, for instance, is typically daily, while a Certificate of Deposit (CD) will compound either daily, monthly, or semi-annually. Home equity loans, student loans, and personal business loans will compound monthly. Frequent compounding will allow more opportunities for your money to grow.
4. Compounding periods
How long are you planning on keeping your money invested? The answer to this question will determine how much your money can grow. If you withdraw your money after five years of compounding, it will have much less opportunity for growth than if you were to leave it for ten years or more. The higher the number of compounding periods, the larger the compound interest will be.
5. Deposits and withdrawals
Finally, do you plan to deposit or withdraw from this account? If you’re making regular deposits, you’ll be growing your principal and additional interest earnings, while frequent withdrawals will dilute the power of compounding. The pace at which you either add to or withdraw from this account will impact the total money you make over the long term.
Calculating compound interest
There are a few different ways to calculate compound interest, and if you don’t want to run the numbers yourself, you can use an online calculator to do the sums for you.
This is the compound interest formula:
A = P (1 + [r / n]) ^ nt
A = The total amount of money that’s accumulated after n years
P = the initial principal amount
r = The annual rate of interest (in decimals)
n = The number of times the interest is compounded per year
t = The time, that is, the number of years the amount is deposited for.
There are a number of tools and compound interest calculators online that will help you calculate compound interest. This free compound interest calculator will ask you a few basic questions before running the numbers for you. If you want something more sophisticated, the compound interest calculator at Financial-Calculators.com will show interest earned, future value, annual percentage yield (APY), and daily interest.
How to take advantage of compound interest
The power of compound interest is unbeatable, but to fully benefit from the magic of compound interest, there are a few key things to keep in mind.
1. Start saving early
Compounding only works when it’s done consistently over a long period. You’ll see your money growing in the early years of saving, but it really starts multiplying with time as the accumulated interest alone becomes a large sum.
An excellent way to understand this is through the Rule of 72. The Rule of 72 allows you to see how your investment will grow over time. Simply divide 72 by the expected rate of return. The answer is the number of years it will take for your investment to double in value. At an expected rate of return of 10%, for instance, it would take your investment 7.2 years to double in value.
2. Compare APYs
The annual percentage yield, or APY, is a better metric to look at than the annual percentage rate, or APR. This is because APY shows the effective interest rate of an investment and considers all the compounding, which the APR doesn’t. Comparing the APY of two accounts or investments is a way to show which pays more interest.
3. Check the frequency of compounding
The more frequently the interest is compounded, the more money you will make. Ideally, your savings product or investment would compound daily, but that isn’t always the case, and it’s important to know whether interest is compounding daily, monthly, or annually. Savings accounts, including high-yield savings accounts, checking accounts, and money market accounts, will often compound daily, while for home mortgage loans, home equity loans, personal business loans, and credit card accounts, the compounding schedule is monthly.
4. Pay down debt
Compound interest can be your best financial friend if you’re saving money and earning interest on that money. But compounding can be your worst enemy if you’re in debt and paying interest charges. Compound interest is why credit card debts can quickly spiral out of control. With lenders applying very high interest rates monthly, even smaller account balances can balloon up in a very short amount of time.
The bottom line
Compound interest is a boon for investors because it can help multiply your money over time. However, it’s important to remember that just as compound interest can grow your money, if you’re paying compound interest on debt, it can spiral out of control very quickly. However, if you start saving early, the power of compound interest can ensure your money is working for you and not the other way around.
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