What Is Compound Interest?
• With compound interest, any interest is added to the principal, and interest is then calculated on the new total.
• Compound interest can accelerate your savings, especially over the long term.
• Some debts also accrue compound interest.
You’ve probably heard that it’s important to start saving for any goal early. But that’s not just because it takes time to save enough to meet your goal. It’s also because savings accounts and other financial instruments pay interest on the amount you’ve put away.
Interest is expressed as a percentage of the money you’ve put into savings. Your bank pays you this percentage for the privilege of holding your money. As you are earning interest, your savings grow much faster than if you were simply stashing money under the mattress. And with the magic of compound interest, even small amounts of money can grow into bigger piles of cash over time.
How Interest Works
There are two types of interest: simple interest and compound interest. Let’s say you put $1,000 into an account that offers a simple interest rate of 2% per year. If you leave your money in that account for one year, you’ll have $1,020 at year’s end (your original balance of $1,000, plus $1,000 x .02). If you leave the account alone for 10 years, your savings will total $1,200. After 20 years, you’ll have $1,400, and so on.
Many loans, including auto loans and most mortgages, charge simple interest. As a borrower, you receive an amortization schedule that shows what your monthly payments will be and how much interest you’ll pay over time. The interest is calculated at the outset of the loan, and the amount you owe won’t grow over time. As a result, you won’t face increasing payments and longer loan terms on loans calculated with simple interest.
How compound interest works, by contrast, is that accumulated interest is periodically added to your principal—the amount you’ve put into the savings account—and begins earning interest, too. Essentially, your interest starts earning interest of its own. The interval at which that interest compounds varies from institution to institution. On some accounts, interest compounds daily, weekly or monthly; other accounts compound semi-annually or annually. And the shorter the interval, the more quickly the principal will grow.
How Compound Interest Affects Savings
The simplest tool for accruing compound interest is generally a savings account, and high yield savings accounts generally offer higher interest rates than regular savings accounts. Let’s say that instead of saving your $1,000 in an account earning simple interest, you find a savings account that pays compound interest at that same rate of 2%, and interest compounds monthly.
If you leave your $1,000 in that account for 20 years, your savings will grow to $1,491.33, according to this Investor.gov compound interest calculator. You’ve invested the same amount of money at the same interest rate as in the earlier example, but thanks to the power of compound interest, you’re earning $91 more.
Certificates of deposit (CDs) and money market accounts also typically pay compound interest, and some compound daily, giving you an even higher yield. While most CD rates are locked in for the CD’s term, money market rates are variable and can change at any time. When your interest rate changes, it will change the amount you earn per interval.
What Does APY Mean?
Annual percentage yield tells you how often accrued interest is compounded. Compound interest demonstrates the most dramatic effects when you save long term. That’s because for each compounding period, you earn more interest than you did before—even if you haven’t made any new contributions to your savings. But it’s a good idea to keep contributing because doing so will intensify the compounding effect.
That’s why it’s important to always start saving as early as you can—even if it’s only a small amount. The sooner you start saving, the more compounding will work in your favor.
How Compound Interest Affects Borrowing
Quickly compounding interest can benefit you as an investor, but it can also work against you as a borrower. When it’s attached to debt, interest adds to what you owe. While mortgages and auto loans generally don’t charge compound interest, some debts do—including credit cards, student loans, and other personal loans.
Additionally, student loans are generally structured to be paid off in a certain amount of time, however, the compounding interest on a credit card continues to accrue. That’s true, especially if you make only the minimum payment due each month and keep spending—all of which adds to the balance.
To reduce the impact of compound interest on borrowing, you can pay credit card bills early in the billing cycle and pay more than the minimum monthly payment. And for other types of loans, you can make extra payments solely toward principal.
This chart is titled "The Power of Compound Interest" When Maria was born, her parents opened a savings account for her. When she grows up, she’ll be able to use this money to help pay for college, a down payment on a car or another big expense. Maria’s parents decide to put $1,000 in a high yield savings account. Every year, they contribute another $1,000 to the account as a birthday present. This account has a 2.25% APY that compounds daily and no maintenance fee. In 30 years, the account will have $31,000 contributed dollars and $14,294 in earned interest for a total balance of $45,294. Source: Compound Interest Calculator, NerdWallet.com, 2019.
Donna Sellinger is a writer and educator living in Philadelphia.
Now that you’ve seen how compound interest can speed up your savings, learn about its effect on loans of all types.
This article is part of Riverstones Vista Capital ’s Personal Finance Series: Level 101. View all topics in the series here.