The Magic of Compound Interest, Explained

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Updated on Thursday, February 14, 2019

“Interest” isn’t always the nicest word. When you borrow money or use your credit card, you pay it back with interest. This is the cost of borrowing. But when you’re investing, the more interest you earn, the more money you make. This is the perk of investing.

While earning interest on your investment is nice, why not let your interest work for you? That’s where compound interest comes in.

What is compound interest?

Compound interest is the interest you earn on your interest — in other words, it’s money you earn on the money you’ve already earned.

Compound interest is important because you’re earning twice: once on the principal and once on the interest. The alternative is simple interest, which is the money you’ve earned only on the principal.

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How does compound interest work?

Before learning how compound interest works, it’s important to know what simple interest is. If you have $1,000 in a simple interest savings account with a 5% interest rate, you’ll earn $50 each year. After three years, you’ll have a total of $1,150.

Simple Interest
Year 1$1,000 x 5% = $50
Year 2$1,000 x 5% = $50
Year 3$1,000 x 5% = $50
Total amount:$1,000 + $150 = $1,150

Pocketing an extra $150 is great, but compounding interest could earn you more. Let’s say you have the same $1,000 original investment with 5% interest compounded annually. You’ll earn $50 that first year. The second year, however, you’ll earn interest on the additional $50 you received last year, earning a total of $52.50 in year two. The third year, you’ll earn $55.13. After three years, you’ll have $1,157.63.

Compound Interest
Year 1$1,000 x 5% = $50
Year 2$1,050 x 5% = $52.50
Year 3$1,102.50 x 5% = $55.13
Total amount$1,102.50 + $55.13 = $1,157.63

While an extra $7 might not seem like a lot, especially throughout three years, imagine what your return would be for $10,000.

Year 1$10,000 x 5% = $500
Year 2$10,500 x 5% = $525
Year 3$11,025 x 5% = $551.25
Total amount$11,025 + $551.25 = $11,576.25

The compound interest you earn on $10,000 over three years is $1,576.25. The more money you earn over time, the more your money will grow. In 10 years, you will have $16,288.95 and your original investment will have grown by 62% — without you adding another dime.

While it’s best to continue to add to your investments as much as you can, it might not always be possible. The major perk of this is that even if you didn’t add any more money to your account, your balance would still increase.

What factors determine how much you earn with compound interest?

When you want to build on your compound interest, here’s what affects how much you earn:

  • Initial investment. This is the money you originally put in. Think of the $1,000 or $10,000 from earlier.
  • Monthly contribution. This is how much you’re going to add to your account every month to build on that initial investment. It’s not required but encouraged.
  • Length of savings. How long are you planning to save money in this account? The longer your money is allowed to accumulate interest, the more you’ll earn.
  • Interest rate. This is how much your money earns each period, and varies depending on the lender. Consider our 5% example from earlier.
  • Compound rate. This is how often your interest will compound. For instance, your interest may compound annually, semiannually, monthly or daily. The more frequently interest compounds, the more beneficial it is for the person earning interest.

Since the interest and compound rates vary by institution, your return will be different based on the lender you choose.

How to harness the power of compound interest

If you’re trying to make the most of your money through compound interest, there are a few steps you can take to get the most bang for your buck.

  • Find a high-yield savings account. The lender with the highest interest rate means you get the highest return. Some lenders have an account minimum, so make sure you have the cash to meet this before signing up.
  • Reinvest interest. Take the interest you earn and put it to work. Reinvest your interest by putting it back into your investment accounts. The more you put into your investments, the better rate of return.
  • Look for low monthly fees. Is your bank or broker charging you to maintain your account? Find a place that doesn’t take a lot of your money for operating costs.
  • Try to make regular contributions. Money that you earn in interest is a sweet deal. But it can be sweeter if you have even more cash to earn interest on. Remember the difference between $1,000 and $10,000.

Take advantage of compound interest

For risk-averse savers, leveraging compound interest is an easy way to grow their cash. High-yield savings accounts that offer this can be a savvy place to stow your emergency fund or other money you’re not willing to risk.

But if you’re looking to grow your money for major goals, a savings account might not be enough for you. Even a conservative investment account through a robo-advisor might yield a higher average return than an account that offers compound interest.

Compound interest accounts are a great way to have your money work for you, but not all firms and lenders offer the same benefits. See which ones have low fees and put the most money possible toward your investments. Your desired return on investment might choose for you.

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