As you build your financial plan and make investment and savings decisions, you may be introduced to the idea of compounding interest. For some, compounding interest can feel like magic but essentially, it helps make your money work best for you.
According to Albert Einstein, “Compounding interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t, pays it.”
Read on for our introductory guide to compound interest so you can be one who understands it.
What is compound interest?
Essentially, compound interest is interest that is accumulated on both your original principal or starting deposit as well as all accumulated interest from previous periods. Compound interest is often mentioned in comparison to simple interest, which is only calculated and earned on the principal.
The practice of compound interest can be applied to standard interest bearing accounts like savings accounts as well as investments or loans. For savers or investors, compound interest means that investments grow faster but for borrowers, it can mean more interest paid on a loan.
How compound interest works
As mentioned above, compound interest is interest that is calculated on both the initial principal and all accumulated interest from previous periods. Compound interest can be calculated on a number of different frequencies including daily, monthly, or annually. In each of these cases compound interest is calculated by multiplying the initial principal by one plus the annual interest rate raised to the number of compound periods minus one. The total initial principal or amount of the loan is then subtracted from the resulting value. Conversely, simple interest is paid at the same rate year over year.
Example:
You have taken out a loan for $10,000 into an account with a 5% annual interest rate over 3 years.
With simple interest, you will owe $1,500 on that $10,000 loan over the 3 years – or $500 each year. Simple interest is calculated as such: $10,000 x 0.05 x 3 = $1,500.
With compound interest, the interest will change each year because it takes interest into consideration with each calculation. In the end you will owe $1,576.25 with your yearly interest amounts being Y1 = $500, Y2 = $525, and Y3 = $551.25. For compound interest the equation is as follows: $10,000 x ((1+0.05) x 3−1) = $1,576.25.
When calculating compound interest, it’s important to pay attention to a few key factors:
- Interest Rate: The rate you will earn or be charged. The higher the rate, the more money you earn/owe
- Starting Principal: The amount of money you are starting with (either deposit or loan)
- Compounding Frequency: How often your interest will be compounded. Compound interest can be calculated on a variety of scheduled and the more frequent the higher the return or owed.
- Length: How long will you own this account or will you be paying off this loan?
Pros and cons of compound interest
As previously mentioned, compound interest can be both good and bad – depending on where it’s coming into play.
Because compound interest is commonly used in a number of financial vehicles, you’ve likely already seen it in action. Take, for instance, your credit card interest. Many credit cards will compound your interest daily – meaning that your amount owed can add up very quickly.
In general compound interest multiplies money more quickly than simple interest because it takes the interest of previous periods into consideration. For your accounts and investments, this means they will grow faster – but it also means the same for your loans, making them more difficult to pay off. For any type of loan or investment, it’s important to make sure you understand the method of interest accumulation and the annual percentage rate being used. These two pieces of data can help you to calculate your expected interest.