What is Compound Interest?
Compound interest is interest that you earn from interest. A simple example of this is if you have $100 in your bank account with a 1% APY, you will earn $1 in interest after one year. In year 2, you would earn 1% APY on the new balance of $101, which would be $102.10.
In this case, you earned an additional $1 on your $100 principal and then $0.10 on your $1 of interest from the previous year. As the years pass, your principal would continue to earn interest, and your interest would continue to compound. This is how compounding and compound interest work.
Deeper Look at Compound Interest
You'll generally earn interest on a savings account or money market account. Additionally, investments pay interest, and using interest earned through investments, an individual can grow their wealth over many years through their interest compounding.
For example, an investor with $100,000 in an investment strategy that earns an average of 8% per year would have $240,387 in 10 years. Of that, $140,387 would be from interest. After 20 years, the initial $100,000 invested would become $533,572.64, and after 30 years, the $100,000 would become $1,184,339.38.
This exponential growth demonstrates how powerful compound interest is, especially over a long period of time.
But, compound interest can also work against you. For those who have credit card debt with high interest credit cards, compound interest can cause you to pay much more money than the initial principal balance if the balance is paid down at a rate slow enough to let the interest accrue month to month for many months or years at a time.
How to Make Compound Interest Work for You
There are three main ways that compound interest will work in your favor, allowing you to build incredible wealth under the right circumstances.
Start Saving and Investing Early
Time is an important factor when it comes to compound interest. The longer your money has time to grow, the more interest that accrues, given a positive return.
Here is a classic example of how time significantly affects how compound interest affects your return.
John is 20 and invests $10,000 per year for 10 years. At 30, he stops and never invests again. From the time he started investing at 20, until age 50, John sees an average return of 8% per year. Due to compounding, John now has $675.212.45
Amy waits until she's age 30 to invest. She invests $10,000 per year from the time she's 30 until she's 50, or 20 years total. In short, Amy invests for twice as many years as John does, however, she waits 10 years to invest. Amy also earns an average return of 8% per year. At age 50, Amy will only have $457,619.64.
The lesson from the story is even though John only invested half as much money as Amy, he had significantly more money at age 50 because his money had 10 additional years to grow.
The APY of the interest also significantly plays into how much money you will earn over the long run. The higher the rate, the more interest you'll earn, which means the more compound interest you'll earn as well.
Using a simple example, let's examine what happens over 30 years when you have $10,000 in each of two accounts. One account contains $10,000 and earns 2% APY. The second account contains $10,000 and earns 3% APY.
After 30 years, the account earning 2% APY will have a balance of $18,579.53. On the other hand, the account earning 3% APY will have a balance of $25,315.69. In this case, a 1% difference caused the account earning 3% APY to end up with $6,736.16 more than the account earning 2% APY after 30 years.
Look at the Compounding Frequency
Knowing the compounding frequency will also help you determine how much money an account will earn. More often is better. For example, if you have the option to go with one of two accounts with the same interest rate, it often makes sense to go with the account with the higher frequency, such as daily versus weekly, or weekly versus monthly.
What is the Rule of 72?
The rule of 72 states that you can approximately double your money in X years given the formula X = 72/i, where i is the interest rate. So, if you had an interest rate of 8%, then i = 8, and the formula would read X = 72/8, or X = 9. Since X = 9, then with an interest rate of 8%, you would approximately double your money in 9 years.
As you can see by this rule, the higher the interest rate is, the quicker your money will double.
What are the Pros of Compound Interest?
Compound interest works in your favor when you invest money and earn an interest rate that compounds regularly. For example, if you invest $1,000 per month for 60 months, or 5 years, and you earn a 9% annual return, then you would have invested a total of $60,000, and your balance at the end of 5 years would be $75,424.16. That means you earned $15,424.16 from interest.
Some ways to get access to compound interest that grows in your favor include:
- Putting money in a savings account
- Investing in index funds
- Trying out peer-to-peer lending. Note, this is a more advanced investing technique that you should do research on before jumping in
- Setting aside money in your 401(k) or other retirement accounts
What are the Cons of Compound Interest?
Compound interest is detrimental to you when it comes to debt. For example, if you have credit card debt that you're having trouble paying off, then the credit card's interest rate, or APR, negatively affects you by increasing how much you owe each month in the form of interest owed.
When compound interest is working against you, such as with debt, it makes sense to pay down those debts as quickly as possible. This is particularly true for high interest debt like credit cards. High interest personal loans are also an example of debt that should be paid down as quickly as possible.
The definition of “high interest” varies, but most agree that if you're paying more than 6-8% interest, then you should focus on paying down those debts as best as you can.
Compound Interest versus Simple Interest
Simple interest is only based on the principal amount of a balance. For example, if you have a loan for $3,000 with a 5% interest rate for 4 years, then the total interest would be $3,000 x 5% x 4 if the interest was simple interest. This would total $600, and you would owe a total of $3,600 at the end of the loan.
Why is Compound Interest Preferable to Simple Interest When Investing?
When you earn compound interest, you earn money on both the principal and the previously earned interest. On the other hand, when you earn simple interest, you only earn interest on the principal. When it comes to investing, you'll earn considerably more money when you're earning compound interest versus if you were earning simple interest.
Can You Get Rich From Compound Interest?
Compound interest can make you rich if you invest for the long run. Even small periodic investments can build massive amounts of wealth over the right amount of time, thanks to the effects of compound interest.