“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” - Albert Einstein
Take it from Mr. Einstein, you don’t want to miss out on the powerful tool that is compound interest. Whether you’re looking for the compound interest of a loan, savings account, or investment, it’s important to understand how money can grow even when it’s essentially just sitting there.
What is compound interest?
From an investment perspective, compound interest (also called compounded interest) is money that you make on money that you make. When you put money in a savings account or other investment, the interest that you earn snowballs. You earn interest each year not just only your initial investment, but also on interest you've earned up to that point.
A simple example of compound interest
Say you put $100 in a savings account at your bank. The annual interest rate is 5%. If the bank gave you 5% of your $100 at the end of the year, you would have $105 on December 31 ($100 x 1.05 = $105).
If you left the $105 in the account to earn another 5% next year, at the end of that second year, you would have: $105 x 1.05 = $110.25. Not only did you earn interest on your original $100 in year two, you earned interest on year one's total ending balance.
How to calculate compound interest
You can use the compound interest formula:
A = final amount
P = initial principal balance
r = interest rate
n = number of times interest compounds per time period
t = number of time periods you're trying to calculate for
Or, you can just use our free calculator instead!
Why compound interest matters
If you’re not taking advantage of the highest possible interest rates on your savings or investment accounts, you’re leaving money on the table. It’s as simple as that!
How to make compound interest work for you
- Invest early – the earlier you start, the more time you have to gather interest on your accounts.
- Invest regularly – Invest as often as you can. Aim for weekly investments, monthly if you must, but don’t settle for quarterly investments
- Hold as long as you can – The longer you hold an investment, the more time you have for your earnings to compound.
- Choose your interest rate wisely – When considering an investment, interest rates matter. The higher the annual interest rate, the better the return. Don’t leave any money on the table.
- Remember compounding periods – The more frequently investments are compounded, whether it be daily, weekly, monthly, or quarterly, the more interest you’ll earn. Keep that in mind when choosing a savings or investment account.
How to start earning compound interest
The good news is that you may have already started with compound interest, and you didn’t even know it. Bank accounts like savings accounts and 401(k) accounts, accrue interest and the interest on these accounts compounds.
If you’re looking to up your compound interest game, you could try index investing or swapping your savings to an account with a shorter compounding period or a higher APR.
Glossary
Annual Interest Rate/Annual Percentage Rate - (sometimes called APR) a percentage that represents the actual yearly interest rate for a loan, investment, or savings account.
Accrued Interest/Accumulated Interest - the amount of interest that has already occurred, but has not yet been paid to the account holder.
Compounding Periods - the span of time between when interest was last compounded and when it will be compounded again. I.e. annual compounding means a full year will pass before interest is compounded again.
Periodic Interest Payments - the number of times interest is being paid for each unit of time (i.e. each year) });
Principal Amount - The original amount of money in an account, loan, or investment before any interest is applied.
Rate of Return - The net gain or loss on an investment over a specified time period, expressed as a percentage of the investment’s initial cost.
Rule Of 72 - A quick, useful formula that is popularly used to estimate the number of years required to double the invested money at a given annual rate of return. Simply divide 72 by your current interest rate, and you’ll have your rough number to work with. If you want to know what interest rate you need to earn in order for your money to double within a certain number of years, just divide 72 by the number of years and you'll have an approximate answer!