What Is Compound Interest And How Does It Work?
Compound interest certainly holds a lot of allure. It’s been called "the eighth wonder of the world," "mankind's greatest invention," "the greatest force in the universe" and more.
These descriptions might pique your interest, but what is compound interest, how does it work and why is it so transformative? Let's find out.
What Is Compound Interest?
Compound interest is interest that accrues based on the original principal amount in an account or on a loan, plus the interest paid or charged each month. In other words, interest gets calculated on the principal amount and the accumulated interest of previous periods, which some people refer to as "interest on interest."
As interest builds on interest, it creates a buildup effect and can result in a considerable payout for individuals. This is called accrued interest, and it's the measure of your loan’s annual cost, including compounded interest.
The Difference Between Simple Interest And Compound Interest
You might have heard of two different types of interest – simple interest and compound interest. The difference between the two has to do with how both are calculated. Simple interest accrues on the principal amount and does not compound. It is interest earned on the amount of money in the account. For example, the interest earned on standard savings accounts is typically classified as simple interest.
Compound interest goes hand-in-hand with simple interest because you earn interest on the simple interest that the bank or financial institution pays account holders. However, compound interest is also based on the principal amount plus the interest that has compounded over previous periods. Interest might compound at an annual interest rate, or it might also compound semiannually or quarterly. Many investment types benefit from compound interest.
How Does Compound Interest Work?
Let's go over a couple of examples of how compound interest might work. For example, let's say you have a savings account that earns a set interest rate from the bank. The bank pays that interest into the account. The account then continues to earn interest on the deposits made by the account holder and the interest payments made by the bank.
Here's another example of how compounding works on interest charges: When someone carries a balance on their credit card, the credit card company charges interest on the remaining balance. The interest gets added to the balance and the next month’s interest is charged on the original balance plus any interest charges.
How do you calculate compound interest yourself? You can quickly determine how much interest you might earn on an investment by using the compound interest formula:
A = P (1+r/n)^nt, where:
A = Accrued Amount of Principal (plus interest)
P = Principal (the original amount invested)
r = Interest Rate (in decimal form)
n = Number of Compounding Periods
t = Time in Years
Here's how using this formula works. Let's say you plan to invest $10,000 at an interest rate of 6% and are curious about how much your investment will be worth in 10 years. Let's say that the compound interest period, which is the timeframe in which interest was last compounded and when it will compound again, is twice a year.
In this case, the formula looks like this:
A = $10,000 (1+0.03)^2(10)
When you finish calculating, A = $18,061.11.
As you can see, as interest accrues, it can help you increase your investments over time. If you don't feel like figuring out how compounding works by putting pen to paper, consider using a compound interest calculator. A calculator will allow you to quickly figure out how much you can earn with your investments over time.
What Types Of Accounts Offer Compound Interest?
There are a wide variety of options, though how various types of investments compound and earn interest affects the actual amount you'll earn. Here are some investments that compound:
- Stocks: A stock represents a small fraction of ownership of a corporation. Owning stocks over the long term can allow you to benefit from compound interest.
- Mutual funds: Professionally managed mutual funds pool a number of investors' money to invest in securities like stocks, bonds and other investments.
- Certificates of deposit (CDs): CDs are a type of investment account in which you deposit money for a preset amount of time. Over time, the interest you earn on a CD is added to your principal.
- High-yield savings accounts: A high-yield savings account is a savings account that offers you a higher return on your investment than a regular savings account.
- Real estate investment trusts (REITs): REITs are companies that own and often invest in income-producing real estate, such as office complexes, apartment buildings, shopping centers, malls, hotels and more.
Keep in mind that compound interest also accrues on debts, such as credit cards.
The Pros Of Compound Interest
What are the benefits of compound interest? Let's take a look.
It Helps You Build Savings Faster
Compound interest allows you to make a sum of money grow much faster than you would compared to earning simple interest alone. In addition to earning returns on the money you invest, you receive the returns at the end of the compounding period. Compounding creates accelerating growth because your original investments plus income from those investments all compound.
Compound interest is typically included in the account. This means that as an account holder, you won’t have to pay extra to grow your savings at a faster rate. You only need the right ingredients to make it happen: principal, interest, compounding periods and the months and years to make it happen.
Time Works To Your Advantage
The longer you have money in an investment account and the more you contribute to it, the more money you'll have in the account. Your interest rate also makes a difference, as does your starting investment amount. All of these factors add up and compound interest starts to take hold, generating more money for you over the long run.
The Cons Of Compound Interest
Now, what are the cons of compound interest? Believe it or not, there are cons to what seems like a positive force at work on your investments.
It Can Work Against You
Compound interest can also work against you. For example, credit cards often implement daily compound interest. This means that you add to your debt when you don't pay off your credit cards from month to month.
The combination of a high interest rate and daily compounding can make it difficult to pay off your credit card. This can significantly increase the amount that borrowers owe, which it's why it's to your advantage to pay off your credit card every month.
Some types of loans, such as federal student loans and mortgages, generally don't charge daily compounding interest.
It Takes Time To Build Up
Compound interest may not offer a quick rate of return for account holders. The smaller your account balance, the smaller the amount you'll earn in interest payments. As account balances grow, interest payments will increase, too. Also, the more money you add to the account over time, the more quickly you'll boost your account balance.
For example, let's say you start out with a $5,000 initial principal amount. Let's say you add an additional $500 to the account per year at a 6% interest rate that compounds one time annually. After 10 years, you'll have $15,940.06.
Now, let's say you start out with a principal of $5,000 like before. Let's say you don't add any money to the account and it compounds one time annually at a 6% interest rate. At the end of 10 years, you'd have just $8,954.24.
Another scenario: Let's say you still start out with a principal balance of $5,000. If you never add any more money to the account and the investment compounds one time annually at a 3% interest rate, you'll have $6,719.58 at the end of 10 years.
Now, let's walk through how a large investment might compound over a long period of time. Let's say you start out with $50,000 over the course of 40 years. Let's say you add $10,000 to this amount every year at the start of the year, at an 8% interest rate that compounds annually. You'd have $3.8 million after 40 years.
As you can see, the more you put toward the investment – principal, interest and time – the more you will experience higher returns.
Fees Are Always Involved
The downside to investing is that you'll always pay fees to make it happen. It isn't free. For example, mutual funds always charge an expense ratio. You may also pay annual and custodian fees, loads and commissions. This can eat into your investment costs and decrease the effects of compounding on your investments.
The Bottom Line: Compound Interest Makes Saving Faster Possible
Compound interest is one of the most exciting mathematical formulas you can apply to real life.
While simple interest has a fixed interest rate based on the principal amount of the loan, compound interest accumulates over time, applying interest to the total amount owed as it changes. Compound interest can also accumulate positively on your portfolio, such as in the case of investments like stocks, mutual funds, CDs, high-yield savings accounts and REITs.
There are many perks of compound interest. It can help you build savings faster, it's free, and time works to your advantage. There are some downsides to compound interest, however. It can work against you with some types of debt. It also takes time to build up – it's not an automatic process. You may need to have years of investing on your side in order to earn the amount of money you envision.
Visit the Rocket Mortgage® Learning Center for more tips to help you streamline your finances and learn more about understanding how different types of loans work.