Compound Interest: What it is and how it works
Compound interest is the interest on savings calculated on both the initial principal invested and the accumulated interest from previous periods.
“Interest on interest,” also referred to as “the power of compound interest,” is believed to have originated in 17th-century Italy. It makes the sum in question grow much faster than simple interest does, due to simple interest only being calculated on the principal amount.
Learn about the mathematical principle that can transform your savings.
You have likely heard about how important it is to start saving early in life. The reasoning behind this? Compound interest!
Compound interest is a mathematical principle where interest accrues not only on the amount you invest, but also on the interest accrued on that amount. As time goes on and interest keeps accruing, the amount builds far more rapidly than what would otherwise be possible without compound interest.
For example, let us say that you invest $1,000 with an interest rate of 8%. At the end of the year, your investment will grow to $1,080 under the simple interest method (which, of course, still results in you building your initial investment). However, with compound interest, as time goes on, the interest will accumulate not only on the amount that you invest (the $1,000) but also on the interest earned on that initial investment ($80 for year one).
This contrasts with simple interest, in which you earn interest only on the original amount day after day or year after year.
Negative compound interest in loans
Most commonly, we talk about the power of compounding interest when it comes to saving and investing. However, there is a flip side to this. Compound interest can also apply to interest on loans that you have taken out, and therefore affects the money that you will owe over time.
For example, leaving a $200 balance on your credit card at 24% interest may only be $48 dollars in interest, but if you leave the balance for another month, you’ll be paying $59.52 interest on the new $248 balance, and this high interest rate debt can grow exponentially!
Even simple interest, which saves borrowers money over compounding interest, can have a large overall impact, especially on high loan balances such as a mortgage or student loan.
The average American will pay $142,614.31 mortgage interest over their lifetime.
The three factors that affect the amount of interest—positive or negative—are simple versus compound, frequency interest is accrued, and interest rate.
The more frequent the interest schedule, the more interest you earn or owe.
Interest can be compounded on any given frequency schedule, ranging from daily to annually. There are standard compounding frequency schedules that are usually applied.
The commonly used compounding schedule for savings accounts at banks is daily. For a certificate of deposit (CD), typical compounding frequency schedules are either daily, monthly, or semiannually; for money market accounts, it’s often daily.
For home mortgage loans, home equity loans, personal business loans, or credit card accounts, the most applied compounding schedule is monthly.
The more frequently your interest compounds, the more you will accrue over time—or owe (in the case of compounding interest on loans).
The higher the interest rate, the greater the interest.
Depending on the type of investment or loan, you may see interest rates anywhere from 2% to 30%, and this has a massive effect of your total interest, especially when it’s compounding.
Let’s consider this example: say you invested $10,000 with a 5% compounding interest rate over five years. This means you will earn $500 in interest in the first year, $525 the second year, and $2,762.82 at the end of five years.
Now, let’s say that the interest rate increases to 10%. In this case, you would earn $1,000 in interest in the first year, $1,100 in the second year, and so on until over the 5 years, you would end up earning $ 6,105.10 in interest, over twice as much as you would have with the lower interest rate!
While this seems like exceptionally straightforward math, not all interest rates are locked in over the duration of your loan or investment. With variable interest rates, the rate goes up or down depending on the markets or other factors.
Fixed interest remains the same over the duration of the investment or loan period.
Variable interest rises or falls based on the state of the markets or other factors.
The benefits of investing early, thanks to the power of compound interest.
Compound interest has the ability to magnify one’s investment in ways that can’t be matched by other methods. For example, imagine the following three scenarios:
A 25-year-old starts saving $1,000 a year in her retirement account, earning 8% interest annually. She saves $1,000 each year for 10 years.
A 35-year-old also starts to save $1,000 in his retirement account, earning 8% interest annually. He saves $1,000 each year for 15 years.
Lastly, a 45-year-old starts to save $1,000 in his retirement account, earning 8% interest annually. He saves $1,000 each year for 20 years.
Naturally, you would assume that, out of these three individuals, the 45-year-old would be the one to end up with the most in his savings (since he contributed $5,000 more than the 35-year-old and $10,000 more than the 25-year-old). However, due to the combination of time and compound interest, the 25-year-old is ultimately the one who ends up saving the most, even after contributing the least amount total.
You see, even after the 25-year-old stops contributing $1,000 per year to her retirement account, interest keeps accumulating at such a rate each year that the other two individuals are unable to catch up. This is often referred to as the “snowball” effect. Although both the 35- and 45-year-olds saved for longer periods of time, their money has had less time to reap the benefits of compound interest and grow. With this, they are behind before they have even started.
Compounding interest’s effect on your overall investing and financial wellness strategy
At its simplest, compound interest is the idea that starting to invest early is one of the best ways to increase your savings over time.
However, it opens the door to other considerations, such as where to invest considering the compounding schedule and interest rates—whether fixed or variable.
Additionally, for many people, investing isn’t the only factor in their financial strategy.
Net worth is your assets minus your liabilities, and therefore, if you don’t account for your debt and the negative interest it is accruing, you can watch your investments grow without any change in your overall wealth and wellness.
Not to mention the tax implications that either form of interest leads to…
Compound interest is yet another simple financial principle complicated by the complexity of life!
Still, with the help of a financial professional who can evaluate your complete financial picture and provide insight into loan repayment and investment models, you can begin making informed choices about where to allocate money in your budget, whether it includes extra loan payments, investment contributions, or, in many cases, a thoughtful combination of both.
Compounding interest’s effect on your overall investing and financial wellness strategy
While so much does vary in the realm of compound interest—from schedule to interest rate—time is an element that cannot be changed. One constant with compound interest is that the earlier you start, the more that you can use the constant of time to your advantage.
This is a concept that is crucial to understanding exactly why it’s so important to start saving for retirement early. While it can be tempting to avoid opting into a defined contribution plan to keep more of your money in your pocket—especially early on in your career—it can be extremely difficult to make up for the lost time, and it will surely continue to get more difficult.
To get the most out of your money and to avoid having to work much harder to save a fraction of the amount that you could have, it’s wise to start saving and preparing for the future as soon as possible.
Interested in discussing this topic further with a financial advisor? With professionals licensed in every U.S. state, there is likely a North Star financial professional near you.
This is a hypothetical example for illustrative purposes only and does not indicate the performance of any particular product. These values assume that the currently illustrated non-guaranteed elements will continue unchanged for all years shown. This is not likely to occur, and actual results may be more or less favorable than those shown. This example does not consider the costs associated with investing. Investments will fluctuate and when redeemed may be worth more or less than when originally invested.
Securities offered through Cetera Advisor Networks LLC, member FINRA/SIPC. Advisory Services offered through Cetera Investment Advisers LLC, a registered investment adviser. Cetera is under separate ownership from any other named entity.