Understanding compound interest is key to building wealth or avoiding crushing debt
Compound interestoccurs when previously earned interestis added to the principal amount invested or borrowed. It is commonly described as "interest earned on interest."
- Compound interest can work to your advantage as your investments grow over time, but against you if you're paying off debt, like credit cards.
- If you're borrowing money, you want interest compounded as infrequently as possible; if you're investing, you want interest compounded as often as possible.
Warren Buffet once famously said that his wealth came from "a combination of living in America, some lucky genes, and compound interest."
The billionaire investor meant that the interest his investments earned helped create his fortune. But Buffett also liked to warn people about the dangers of ending up on the wrong side of the compound interest equation.
While compound interest is arguably the most important component to wealth-building, it can also be one of the best ways to wreck your finances: Having to pay compound interest can cause debt to spiral out of control.
Most people only think of interest in terms of how high or low a rate is. But understanding how interest is calculated, or compounds, is important too. Knowing how compound interest works can help you avoid expensive mistakes and make the most of your money, whether you're depositing it, investing it, borrowing it, or spending it.
What is compound interest?
All interest is a percentage charged on, or earned by, a lump sum of money. Compound interest is a kind of interest based on adding the original principal — that is, the initial amount invested or borrowed — with the accumulated interest from previous periods.
For example, say you have $100 in a savings account, and it earns interest at a 10% rate, compounded annually. At the end of the first year, you'd have $110 (100 in principal + 10 in interest). At the end of the second year, you'd have $121 (110 in principal + 11 in interest). At the end of the third year, you'd have $133.10 (121 in principal + 12.10 in interest). And so on.
In other words, with compound interest, you earn interest on interest.
The revelation comes when you realize that compounding interest makes the principal grow exponentially, meaning as interest accrues and the quantity of money increases, the rate of growth becomes faster.
How quickly your money grows depends on the interest rate, and the frequency of compounding. Interest can be compounded daily, monthly, quarterly, or annually, and the more frequently it's compounded, the faster it accumulates.
Over the long term, "the magic of compounding" can really add up. Here's how an initial investment of $5,000 would grow if compounded semi-annually over a period of 35 years, at an annualized 5% interest rate:
If you're the one earning money off the interest, daily or monthly compounding are preferable to yearly. On the other hand, if you're being charged interest, monthly or yearly compounding will save you money compared to daily.
Compound interest vs. simple interest
While compound interest is "interest on interest" — calculated on both the principal amount and the accumulated interest — simple interest is wholly different. Simple interest is calculated only on the original principal balance or deposit.
Let's take our $100 savings account again, only this time it's paying 10% in simple interest. That means the 10% interest rate applies only to your original principal amount of $100, so you earn $10 each year. Period. At the end of the first year, you'd have $110. But at the end of the second year, you'd have $120. At the end of the third year, $130 — compared to $133.10 in the compounded interest account.
Even though we've used small numbers here, you can see how the farther out you go, the more compound interest nets you — and the more it outstrips simple interest.
Simple interest tends to be used in most student loans, mortgages, and installment loans — when you're paying a store for the purchase of a big appliance over a period of time, for example.
How to calculate compound interest
Calculating compound interest looks complicated, but it's actually as simple as plugging some numbers into the right formula.
Let's say you decide to deposit your $10,000 annual bonus into a 5-year certificate of deposit (CD). You leave that money in the CD for the full five years, and it earns a 4% annual rate of interest that's compounded daily. The numbers you'd plug into each variable are as follows:
- P = $10,000
- r = 0.04
- n = 365
- t = 5
The formula gives you $12,213.89 for A. That's the total amount of money you'd have in your money market account at the end of five years. This means you earned $2,213.89 in interest.
How compound interest can work against you
As beneficial compounding interest can be for savings, investments, and wealth creation, it's important to note that it can work against you if you're paying off debt. In fact, compounding is part of what makes carrying an outstanding credit card balance so deadly.
In fact, the above example could be turned upside down by imagining that you carry a $10,000 balance on a credit card (we'll assume it's the same 4% compounded daily, even though credit card APRs are usually much higher). You plan not to put anything else on the card, and to pay it all off in five years. Even though you'd be chipping away at your balance and paying an extremely low interest rate, you could still end up paying a lot in interest charges — more than $1,000 in fact.
And if you were being charged 18% compounded daily — which is closer to the average credit card interest rate — you would pay $5,236 in interest after five years.
How to get the most out of compound interest
The best way to take advantage of compound interest is through saving and investing.
Opting for a savings account that earns interest — such as high-yield savings accounts, money market accounts, and CDs — is one way to make compound interest work in your favor. When choosing an account, you'll want to look for one with minimal fees and the highest annual percentage yield (APY), which is the interest you can earn on your deposit in a 12-month period.
It's worth noting that the
Savings products offer interest rates that typically range from 0.01% to 3%, depending on the state of the economy, while the average historical rate of return on the stock market is 10%, before adjusting for inflation.
When opening an investment account like a 401(k), IRA, brokerage account, or mutual fund, you have the option to automatically reinvest the dividends or interest your investments earn. Doing so means your returns will compound.
The financial takeaway
Compound interest can be your friend or your enemy, with the power to enrich you or bankrupt you — depending which side of it you're on.
Luckily, you don't need to be a math genius to understand whether the interest on an account will help or hurt you. If you're borrowing money, you want the lowest interest rate possible, compounded as infrequently as possible. If you're investing money, the opposite applies: You want not only a good interest rate, but one that compounds early and often.
And when comparing loans, credit card APRs, savings account APYs, or other securities' returns — check the frequency at which the interest compounds, and make sure you're comparing like to like. Two interest rates can be nominally the same, but if they compound at different speeds, it can make a big difference.
Whether earning it or paying it, the nature of compound interest means that getting on top of it early on is exponentially — pun intended — better for your wallet.
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