Compound interest is one of the most important concepts to understand as you manage your finances. When used in your favor, compound interest works to grow your savings – sometimes in a very dramatic way. Here’s everything you need to know about this tricky financial concept and how to leverage it to your advantage.
What Is Compound Interest?
If you understand the “snowball effect,” you understand the basics of compound interest. In the snowball effect, even the smallest ball of the white stuff can grow rapidly in size, building upon itself as you roll it downhill. Compound interest creates this snowball effect with your finances, helping your money build on itself.
Basically, compound interest is interest earned on money that was earned as interest in the past. It creates a cycle of exponential growth, in other words, interest building on interest.
Say you deposit $100 in a savings account with a 5% compounded interest rate. You’d earn $5 in one year. So you’d have $105 in the account. Now for the good part: The next year, you’d earn 5% on that entire $105, or $5.25 (instead of just $5). Without making any deposits or giving attention to your savings account, you earn extra money. So now you have $110.25 in the account, and the next year you’ll earn 5% interest on that. You get the idea. (You can play with the numbers yourself using this compound interest calculator.)
Yeah, we know that doesn’t sound like much. So, take a look at an example with a larger sum of money. Say you deposit $3,000 in an account with a 5% interest rate. You’d earn $150 in one year and then earn $157.50 in interest on $3,150 the next year. The process repeats year after year, and as the balance grows, so does the amount of interest you get.
What Is Simple Interest?
The opposite of compound interest is simple interest. Simple interest doesn’t multiply; it doesn’t build on the previous accrued amount of interest. It just keeps chugging along at the same rate, based on the same initial sum.
If, in our first example above, that $100 was deposited in an account with simple interest, it would just earn $5 each year. The 5% rate would only be calculated on your initial $100 deposit, in other words. The same for the second example: The $3,000 you funded the account with would grow, but only by $150 annually.
Simple interest is most often used with loans. After all, borrowing money is never free. In addition to returning the amount that you borrowed, you also must pay a simple interest rate as your cost of borrowing.
Say you take out a $10,000 loan with an 8% simple annual interest rate to purchase a new car. You agree to pay the loan back over two years. To calculate how much money you’ll pay in interest, multiply your principal amount ($10,000) times your simple interest rate (.08) times the number of years of your loan (two).
10,000 x .08 x 2 =$1,600
This means you pay a total loan amount of $11,600 due to simple interest.
Building Your Money Over Time
Simple interest works to your advantage with debt. After all, you wouldn’t want the amount of interest due on your mortgage or student loan to snowball, increasing the amount of money you owe!
But when it comes to earning money and making your money work hard for you, it’s compound interest that you want. Banks and investment firms offer varying interest rates and terms, so shop around to find the best option.
Some savings accounts only offer simple interest returns. You earn the same amount of money on your balance, regardless of how much it grows. You could leave $10,000 in a savings account at 8% APY for more than 50 years and never accrue more than $50,000.
Compound interest, on the other hand, becomes more rewarding with time. If you invest $10,000 into an account with a compound interest rate of 8%, you’ll have $14,693 after just five years and $21,589 after 10 years. But the real magic happens when you let your compound interest work over decades. After 20 years, you’ll accrue $46,609, and after 50 years untouched, your $10,000 at an 8% APY becomes $469,016.
Any chunk you can stash away will grow faster with a compound interest rate. And It feels pretty good to watch your savings transform with virtually no effort, doesn’t it?
Read about micro-investing and how to get started with our complete guide: Micro-Investing: What It Is, Why It’s for You and How to Start.
