When you deposit funds into a savings account or certificate of deposit, you can benefit from interest helping your money to grow in the account over time. On the flip-side, when you have a credit card or other type of loan, you can see how it can affect you negatively if you end up carrying a balance or not making a payment on time.
Its important to understand how compound interest works and how it impacts your overall wealthfor better or for worse.
What is compound interest?
Compound interest is interest earned on both the initial deposit you make in an account and the interest the account has already accumulatedalso known as, interest on interest. How often interest compounds depends on the frequency cycle which can be daily, monthly, or annually.
Generally, the more often the account compounds, the greater interest is earned. For example, if you have a principal balance of $3,000 in a savings account that earns 2% interest compounding annually, your account would grow to $6,625 at the end of 40 years. But, if your account compounds interest monthly, all else the same, you will have $6,673.
Not only can compound interest increase your savings at a faster rate than simple interest can, it also requires a lower initial principal balance to reach the same target balances. But, its important to note that it can take a while to see a significant difference in your account balanceeven with a faster compounding scheduleso start saving as soon as possible once you have a financial goal in mind.
Previously, we saw an example of a savings account that compounds interest. But there are other types of accounts that benefit from earning interest on interest.
Savings accounts: Savings accounts are a type of bank account that earns interest on the funds held. Funds held in a savings account at a bank or other financial institution can compound interest on a daily, monthly, or annually schedule. The funds are easily accessible through account transfers, withdrawals, and sometimes checks.
Certificates of Deposit (CD): A CD is a type of savings account that earns interest over a set period of time. Typically, a CD offers a higher rate of return than a traditional savings or checking account, but theres a condition that the funds are left untouched during this time period, known as the term. These terms range from three months up to several years and the investment compounds interest daily or monthly while held in the CD. If you choose to withdraw your funds before the term ends, you can be charged an early withdrawal fee and will miss out on potential interest earnings.
Student loans: Compound interest doesnt always benefit the consumer and works against you when you take out loans or credit cards. This includes student loans. While all federal student loans accrue simple interest, some private loan issuers charge interest that compounds annually, monthly, or even daily. This is often called interest capitalization, which is when the total interest accumulated is added to the balance of the loan and begins accruing interest. This can occur after a grace period ends, such as when a student graduates, and can be detrimental for borrowers who are making on-time payments almost entirely toward interest and have trouble paying down their principal balance.
Credit Cards: Like student loans, credit cards compound interest on the balance owed daily, monthly, or annually, making it difficult to get ahead on payments. If you dont pay off your credit card and are charged interest on your purchases, you can quickly get caught in a trap of paying exorbitant prices for everyday purchases like groceries, says Kenneth J. Dean, certified financial planner and senior director of financial planning at Winthrop Wealth, a wealth advisory firm dedicated to maximizing the impact of their clients wealth.
How does compound interest work?
While compound interest may seem complicated, its actually made up of the same components as simple interest along with a few additional pieces.
Principal balance to start: The initial value of funds in an account. For instance, a $20,000 student loan would have a principal balance of $20,000. On the other hand, a savings account can also have a principal balance, such as an initial deposit of $100.
Interest: A small percentage of the sum of the principal balance and previously earned interest. Stated as a percentage, interest is the amount that is either charged to the account owner for borrowing money, or is earned by the account owner as revenue. When youre investing you want a higher interest rate, because a higher rate will take less time for the investment to double, says Dean. But if you are taking out a loan or using a credit card, you want a lower interest rate to lengthen the time it takes your debt to double in amount.
Deposit and withdrawals: Funds coming into or out of an account can impact how much interest the account earns. If youre depositing funds to pay off a student loan for example, youre decreasing the principal balance and amount of accumulated interest, which in turn lowers the interest that compounds on the loan. But if you have a savings account, you deposit funds to increase the balance that earns interest, therefore increasing the overall interest accumulated on the account.
Frequency of compounding: How often your account compounds can impact your interest earnedthe more frequent interest compounds, the more interest you earn. Normally, accounts compound on either a daily, monthly, or annual schedule, but they can also compound on a quarterly or semiannual basis. If you have a credit card that compounds interest daily, its going to take you longer to pay off the balance than if it compounded annually or even monthly, all else equal, says Dean.
Duration: Aside from how often an account compounds interest, another timing factor is how long your savings have to grow. If you have a savings account that compounds on an annual basis, but you withdraw the funds before the year ends, your money will not have had a chance to compound. Instead, you want an investment to compound more frequently because the value will grow to a larger number at the end, says Dean.
How its calculated
If youre curious how quickly it will take your investment to increase in size, you might want to calculate how much compound interest your funds earn. Knowing how compound interest is calculated can also help you understand what factors you can manipulate to reach your financial goals.
For instance, lets say you need to save $15,000 within five years to pay for your wedding. Since you cannot adjust the duration you have to compound interest, you may need to find a savings account with a higher interest rate, like a high-yield savings account.
Sometimes you might be able to adjust the duration for additional compounding periods, but have no power to change how much interest your account earns. No matter what financial goal lies ahead, learning how to take advantage of the power of compound interest formula will help you devise a savings plan. Heres the formula:
A = P (1 + [r / n])(n)(t)
A: Future value of the investment or loan, including interest accumulated
P: Principal balance of the investment or loan
R: Annual interest rate, stated as a decimal point.
N: Number of times interest compounds per year
T: Time in years the balance is invested or borrowed
Lets say you deposit $1,000 into a 10-year CD that earns 5% interest, compounded monthly.
In this example, we are solving for the amount the account will accumulate over time, which is A. We know P = $1,000; t = 10; r = 0.05; and n = 12. So lets plug these numbers into our formula.
A = $1,000 (1 + [0.05 / 12])(12 * 10)
A = $1,000 (1 + [0.05 / 12])(120)
A = $1,000 (1 + [0.00417])(120)
A = $1,000 (1.00417)(120)
A = $1,000 (1.6477)
A = $1,647.67
At the end of ten years, the $1,000 starting deposit will have earned $647.67 in interest, totalling $1,647.67 in savings.
Simple interest vs. compound interest
If you have a car loan, chances are you are being charged simple interest. This is a good thing because simple interest is only calculated based on the principal balance. This means that your lender cant charge you interest on any of the interest your loan previously accumulated over the life of the loanwhich saves you money.
But if you are saving for a long-term goal like retirement, you want to seek out an account that accrues compound interest and earns interest on the total balance of the account including interest earned. This will give you a higher return and benefit you in the long run.
The takeaway
Understanding how compound interest works can help you make informed decisions about your investments and loans. If your goal is to pay down debt, compounding interest can really burn you if you give it time to grow without taking action, and it can quickly erode any type of wealth you are trying to build in your lifetime.
On the other hand, if your investment is compounding interest, the power of compound investing works on your side. You can take advantage of this by starting to save as early as possible which gives your account more time to grow your wealth.
