Compound interest is often described as “magical” because it allows small amounts of money to grow exponentially over time. It’s a crucial financial concept that plays a major role in savings, investments, and even debt management.
Whether you’re planning for retirement, saving for a major purchase, or investing in financial markets, understanding compound interest can help you make informed decisions. This guide will explain what compound interest is, how it works, and how you can leverage it to your advantage.
Key Points
• Compound interest is when you earn interest on your principal as well as the interest accumulated from previous periods.
• Benefits of compound interest include faster growth and protection against inflation.
• To maximize benefits, start saving early and make additional contributions along the way.
• Compound interest outperforms simple interest over long periods, leading to significant gains.
• Compound interest benefits savers but can make debt increasingly hard to pay off.
What Is Compound Interest?
Simply defined, compound interest is the interest you earn on your interest. It comes into play with many interest-bearing financial products, such as savings accounts, certificates of deposit (CDs), and bonds.
Unlike simple interest, which is calculated only on your original money (principal), compound interest accumulates on both the principal and the interest that’s added to your balance over time. This “interest on interest” effect enables investments and savings to grow at a faster rate similar to a snowball rolling downhill, getting bigger and bigger as it goes along.
Compound vs Simple Interest
Simple interest is straightforward: It is calculated based only on the principal amount. For example, if you deposit $10,000 in a savings account at an annual interest rate of 3.50% with simple interest, you earn $350 each year, and after 10 years, you would have $13,500.
Compound interest, on the other hand, takes into account not just the principal but also the accumulated interest. If the same $10,000 earns 3.50% annual interest with monthly compounding, the amount grows to $14,183.45 after 10 years. The difference is due to interest being added to the balance, which then earns more interest over time.
Importance of Compound Interest in Finance
Compound interest plays an important role in finance, as it can significantly impact savings, investments, and debts. It benefits savers and investors by exponentially increasing their funds over time, making it a key principle behind financial growth strategies. On the flip side, it can work against borrowers, as debts can grow significantly if interest compounds frequently.
In finance, the term “compound interest” generally refers to interest calculated on accounts like savings accounts, bonds, and loans. Some checking accounts also earn compound interest.
The term “compound returns,” on the other hand, is broader in scope — it can include interest as well as other types of investment returns, including dividends and capital gains.
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.
Understanding Compound Frequency (Daily, Monthly, Annually)
The frequency of compounding determines how often interest is added to the principal. The more frequently interest compounds, the faster the total amount grows. Common compounding periods include:
• Daily: Interest is calculated and added each day, leading to faster growth.
• Monthly: Interest is compounded 12 times a year, making it slightly less aggressive than daily compounding.
• Annually: Interest is compounded once per year, resulting in slower growth compared to more frequent compounding periods.
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Formula for Calculating Compound Interest
If you want to get technical, there’s a compounding interest formula you can use to calculate your total savings including compound interest over time.
A = P(1+r/n)nt
Where:
A = Final amount (principal + interest)
P = Principal (initial amount)
r = Interest rate (decimal form)
n = Number of times interest is compounded per year
t = Number of years
You could plug numbers into this formula to project your earnings. Or, if you’d rather not get into complicated math, you can use a compound interest calculator to determine how much your savings will grow based on the initial deposit, interest rate, compound frequency, additional contributions, and length of time.
Examples of Compound Interest Calculations
To illustrate how compound interest works, here’s an example using a deposit amount of $5,000 and a 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%
The chart below shows an estimate of how much $5,000 can grow over time using the power of compound interest. These numbers assume that you will earn an interest rate of 10% that compounds annually and that don’t make any additional deposits over the next 10 years.
| Year | Value |
|---|---|
| 0 | $5000 |
| 1 | $5,500.00 |
| 2 | $6,050.00 |
| 3 | $6,655.00 |
| 4 | $7,320.50 |
| 5 | $8,052.55 |
| 6 | $8,857.81 |
| 7 | $9,743.59 |
| 8 | $10,717.94 |
| 9 | $11,789.74 |
| 10 | $12,968.71 |
Benefits of Compound Interest
If you’re looking to grow your savings, compound interest offers some key benefits:
• Accelerated growth. Compounded interest helps money grow exponentially, thanks to its “snowball effect” of your interest earning interest.
• Wealth building: Compound returns can make it easier to reach long-term goals like saving for retirement or paying for a child’s future college education.
• Inflation protection: Earnings from compounding help offset the effects of inflation on your savings over time.
Strategies to Maximize Compound Interest
Compound interest, on its own, can boost savings. Yet, there are ways you can make more out of this financial strategy. Here are some to consider:
• Making additional contributions: Regularly adding to your principal, either manually or through automated saving, amplifies the benefits of compounding. Consider a person who tucks away $1,000 for 10 years at a 6.00% return (compounded annually). At the end of that period, they will have $1,790.85. If the same person made an additional monthly contribution of $100, at the end of the period they would have $17,607.80.
• Switching banks: To get the best return on your savings, it pays to shop around and compare annual percentage yields (APYs). The APY takes compounding into account and makes it easier to compare banking products apples to apples. The average savings account offers relatively low APYs — 0.42% APY as of December 16, 2024. A high-yield savings account, however, may pay 3.00% APY or higher.
• Starting early: “When figuring out how to become financially independent, it can behoove individuals to invest early and often,” says Brian Walsh, CFP® and Head of Advice & Planning at SoFi. “Even if it’s only $25 or $50 per month, small amounts can add up. By investing earlier than later, money has more time to grow and for returns to compound.”
Recommended: How to Switch Banks
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Common Misconceptions About Compound Interest
Here’s a look at some common myths and misunderstandings about compounding.
• It only benefits the wealthy: Compound interest benefits anyone who saves, regardless of their initial amount.
• It works the same for savings and debt: Compound interest is a benefit when you’re saving, but a negative when you’re borrowing. For example, compound interest often applies to interest added to credit card balances, which can make them harder to pay back.
• Short-term results are noticeable: Significant gains that come from compound interest come over long periods, not immediately.
• Higher compounding frequency leads to large gains: While more frequent compounding helps, the effect is marginal compared to the impact of time and rate of return.
The Takeaway
Compound interest helps your money work harder. It allows the interest you earn on your original deposit to earn interest of its own, which accelerates growth. This is in contrast to simple interest, which pays interest based on the principal alone. Any accumulated interest is not factored into future interest payments.
If you’re looking to get a good return on your money, it pays to compare APYs, which tell you how much you will earn on your funds in one year, taking the interest rate and compounding periods into account. You’ll also want to keep an eye out for any account fees, which can eat away at your principal and lessen the impact of compound interest.
Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.
FAQ
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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