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- Compound interest 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.
- A calculator can help predict how much money compound interest will earn over time.
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.
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.
Compound interest calculator
Your balance after 5 years
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.
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 previously earned interest.
Because of this, 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 time, compounding interest 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 is 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.
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How to use a compound interest calculator
To use our compound interest calculator, you’ll need a few pieces of information:
Your initial investment — your starting sum.
The length of your investment. Accounts that earn compound interest are often invested in the stock market, which means they carry some degree of risk. For that reason, experts recommend investing only money you won’t need for at least five years. The effects of compound interest are increasingly dramatic over time, so move the calculator’s slider to see how your interest will grow over five, 10, or even 30 years. However, you can get the best of both worlds — some degree of compound interest plus liquidity — in a high-yield savings account.
Any regular contributions, and whether you will make them monthly or annually. While you can earn compound interest without ever contributing another dollar, additional contributions will speed up the money’s growth. The more often you can contribute, the faster it will grow. Even if you don’t feel you have much to spare, experts recommend setting up an automatic contribution of a small sum — say $20 or $50 — through your bank or brokerage’s website or app, then revisiting that contribution in six months in case you can increase it.
Your rate of return, also known as your interest rate. While past results can’t predict future performance, the average stock market return over the past 10 years is about 14.7%. This doesn’t mean you’re guaranteed this interest rate, or anything near it, so take your final calculations with a grain of salt. However, it’s a decent place to start running your numbers. In some cases, you’ll know your rate of return; a high-yield savings or interest checking account will tell you up front. Note, though, that these products typically have variable interest rates, which mean the rate will change over time.
The compounding frequency, which is how often the interest compounds. It will be daily, weekly, or annually, and the more often it compounds, the faster an account will grow.
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 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 interest rates on even the best savings accounts barely outpace inflation, so they’re best for short-term savings. If you want to build long-term wealth, whether that’s saving for retirement or a goal that’s years away, investing your money will really get it working for you.
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 bottom line
Compound interest can work for or against you depending on whether you’re borrowing or saving money.
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 better for your wallet.