Whether you are first taking the reins of your financial life or have been managing your money for years, you probably know that compound interest can be a powerful tool in growing your wealth. It can be among the reasons why the money you save today can grow much larger as time passes.
It’s pretty common to hear the advice that you should start saving as soon as possible, especially when it comes to stashing away cash for retirement. It can, however, be challenging to accomplish that with all the other expenses that crop up, from student loan debt to high housing costs to inflation hitting you hard at the supermarket.
But even if you can only save a little, you should start as soon as you can. Because the longer you save, the more time you have to watch compound interest work its magic. Here, you’ll learn all about this important financial force, including:
• What is compound interest?
• How does compound interest work?
• What are types of compound interest savings accounts?
• What are the pros and cons of compound interest?
What Is Compound Interest?
Compound interest is a method by which interest is added to money on deposit (the principal). To put it simply, compound interest is interest that is earned on the initial principal and the interest that accrues on it. So if you were to deposit, say, $200 in a savings account and it earned interest of $5 in its first month, the next month of compound interest would be accrued on $205, or the principal plus the interest earned.
Compound interest can allow individuals to build savings, as the initial investment and interest payments grow almost like a snowball rolling downhill, getting bigger and bigger.
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How Does Compound Interest Work?
When talking about interest and how it works, you are likely to hear the terms simple interest and compound interest. Comparing the two can be a good way to illuminate what compound interest is.
Simple vs Compound Interest: What’s the Difference?
Simple interest is when interest is paid strictly on the base amount. Let’s say you were to deposit $10,000 in a bank for one year at a rate of 5%. With simple interest, at the end of the year, you would have the $10,000 principal plus $500 in interest, for a total of $10,500.
With compound interest, however, your money would grow faster. If the interest were compounded daily, at the end of the year you would have $10,512.67, and a year later, you would have $11,051.63, while simple interest would yield a total of $11,000. While it may not sound like a huge difference early on, the results are amplified over time and with ongoing deposits.
Here is a chart that captures the differences between compound vs. simple interest:
|Simple Interest||Compound Interest|
|Accrues on the principal only||Accrues on the principal and interest earned|
|Always calculated annually||Can be calculated at different intervals, including daily, monthly, quarterly, and annually|
|Interest rates typically are fixed, depending on the institution||Interest rates may vary, depending on the account type|
Types of Compound Interest Savings Accounts
Remember, a good interest rate for a savings account is important, but so is the way that the interest accrues. If you are looking for what is known as a compound interest savings account, you will likely have an array of options. Among the different types of savings accounts that can accrue compound interest are:
• Standard savings accounts. These are your basic savings accounts that earn interest and may restrict the number of withdrawals you make per month.
• High-yield savings accounts. High-yield savings accounts typically pay a significantly higher interest rate than conventional accounts. You may often find them offered by online banks.
• Premium savings accounts. These typically have higher account minimum requirements to snag a higher interest rate and other services and features.
• Certificate of deposit (or CD) accounts. Certificates of deposit require you to keep your funds on deposit for a specific term and typically have a fixed interest rate, though there are exceptions to that rule.
• Money market accounts. These often combine features of a checking and savings account.
• IRA accounts, or Individual Retirement Accounts. IRA accounts allow you to save money for retirement in a way that is tax-advantaged.
The Compound Interest Formula
If you want to get technical, there’s a compounding interest formula you can use to calculate savings account interest:
A = P(1+r/n)nt
Let’s break this down. “A” is the final amount of money you’ll end up with. “P” is the principal, or original amount deposited. The “r” is the interest rate as a decimal, so 0.1 for 10%. The “n” is the number of times interest compounds each year, and “t” is the number of years you’re looking at.
The “n” in the formula above — how often interest gets compounded — makes a big difference. If interest is compounded monthly instead of yearly, for example, that can really change things.
Compound Interest Example
Here’s a hypothetical scenario in which $5,000 is deposited and receives a very healthy 10% interest rate that’s compounded annually. After the first year, the account would earn $500. But starting with the second year, the 10% interest would be calculated based on the new amount of $5,500, not just the original $5,000.
Future Value of $5,000 Deposit Compounded Yearly at 10%
|Year||Investment||Interest Earned (10%)||New Balance|
The numbers add up quickly. After 10 years, the account would be worth around $12,951.82. (If you want to see how this works for yourself, an online compound interest calculator can generate hypothetical results depending on the initial deposit, interest rate, additional contributions, and length of time.)
The Rule of 72
Another simple and helpful formula that might be used to estimate compound interest is known as the Rule of 72. This calculation can allow individuals to look at their rate of return, estimating how long it may take before they double their money (with a fixed rate).
For the Rule of 72, it’s possible to divide 72 by the fixed interest rate. In this sort of calculation, the interest rate percentage would be represented by a numeral — not as a decimal. Say an individual has $1,000 that they want to save at a 3% interest rate. To use the Rule of 72, they might divide 72 by the numeral three to find that it could take 24 years to double the principal at this rate.
The Rule of 72 could be a useful tool when deciding quickly between savings accounts or other financial products that offer different possible returns.
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Why Making Additional Contributions Matters
While saving early helps you take advantage of compound interest, so does saving regularly. Say after starting an emergency fund savings account with an initial deposit, you add money each year. That will give compounding interest the chance to grow your funds even further.
Getting results via compound interest doesn’t mean you need to have $5,000 to deposit today. Even small contributions can make a difference. The earlier you start saving and the more time you have, the more of a chance compound interest has to help build your wealth.
To illustrate, let’s revisit the equation above with a smaller hypothetical initial deposit. Let’s say $500 is contributed to a savings account today, compounded annually at 10%, and nothing else was done for 10 years. At the end of that time, the account would have:
A = 500 (1+0.1/1)(1*10)
A = 500 * 1.110
A = 500 * 2.5937424601
A = $1,296.87
But if you wait 40 years, you get a different answer:
A = 500 (1+0.1/1)(1*40)
A = 500 * 1.140
A = 500 * 45.2592555682
A = $22,629.63
That’s quite a jump! And all it took was time.
If you were also to add just $50 a month to that initial $500 contribution, you’d have around $10,860 in 10 years. And after 40 years? You’d have $288,185. Even adding small amounts, especially consistently over time, can pay off, depending on the rate of interest and how often it is compounded.
This type of growth can apply to different kinds of retirement accounts as well.
Pros and Cons of Compound Interest
The pros and cons of compound interest can depend significantly on whether you are earning compound interest or paying it.
On the plus side:
• Compound interest can help your money on deposit grow more quickly, thanks to its “snowball effect” of your interest earning interest.
• The sooner you begin saving with compound interest, the longer you have to reap its benefits of helping your money increase.
However, there can be a downside to compound interest:
• If you are paying compound interest on some kind of debt, you may find it challenging to pay off what you owe since the interest can increase so swiftly.
Making the Most of Compound Interest
Compound interest, on its own, can boost savings. Yet, there are other ways individuals can make more out of this financial strategy.
Saving early and often really matters. Time is compound interest’s “special sauce.” Compounding interest grows exponentially over time. So, the longer an individual can leave their money untouched, the more potential it has to grow.
Try these tactics to increase the power of compound interest:
• Making additional contributions: Whenever they’re possible, extra contributions add to an individual’s principal (the money that accrues earnings), increasing the total savings on which they’ll gain interest and speeding up their potential financial goals.
Consider a person who tucks away $1,000 for 20 years at a 6% return (compounding annually). At the end of that period, they will have roughly $3,200. If the same person made an additional monthly contribution of $100, at the end of the period they could have over $47,000.
• Avoiding making withdrawals: Removing money from an account slows the effects of compounding interest, as it reduces the amount of money on which an individual could earn returns.
• Checking interest and return rates: The higher the rate of the return, the greater the impact it will have on your savings. You may want to consider this factor when choosing savings accounts (or other financial products). The average savings account offers relatively low interest rates — around 0.33% in mid-February of 2023. Looking for a high-yield savings account, where the interest rate can be many multiples of that (say, 13 times higher), can be a smart move.
Stock market investments may offer much higher returns as well, up to an average of 10% to 12%. But keep in mind that there’s always the risk that these investments will lose money, given market volatility.
Compound interest vs. simple interest is a way to earn interest on your money’s principal as well as the interest itself. It can be a good way to accelerate your savings, especially long-term ones. Many different savings vehicles offer compounded interest; check to see the frequency as the shorter the compounding window (say, daily vs. quarterly), the more your money can grow.
Opening an online bank account with SoFi can be a good way to harness the power of compound interest.With a SoFi Checking and Savings account, you’ll also earn a competitive annual percentage yield (APY) and pay no account fees, all of which can help your money grow faster. Plus, you’ll enjoy the convenience of spending and saving in one convenient place.
How much do people typically make in compound interest?
There is no typical amount that people make in compound interest because there are several variables involved: the principal, the interest rate, how long the interest accrues for, and how often it is compounded. To check specific scenarios, you can use an online compound interest calculator.
Is it better to have simple or compound interest?
If you are depositing money and hoping to have it grow over time, earning compound interest vs. simple interest will help it grow faster. However, if you are paying interest on a debt, simple interest will accrue more gradually and therefore be easier to pay off.
Do all banks offer compound interest savings accounts?
Many banks offer savings accounts with compound interest. It can be worthwhile to check to see how often the interest is compounded: daily, monthly, quarterly, or annually. The more frequent the compounding, the faster your money will grow.
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