Compound interest, or compounding, is the key to exponential growth because you earn interest on your interest. It’s how you make your money work for you.
What is compound interest?
Compound interest is powerful because you earn interest on the principal amount plus all of the interest you’ve accumulated. Since the total will continually grow, the amount of interest you’ll receive will also grow larger.
Albert Einstein says, “Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn’t, pays it.”
Einstein is right, and that’s why you need to understand how it works so that you can make money work for you.
The following is the formula to calculate compound interest:
A = P(1 + r/n)^(nt)
- A = The future value including the interest.
- P = The initial principal amount.
- r = The interest rate.
- n = The number of times interest applied per time period.
- t = The number of time periods.
- ^ = To the power of.
Formulas can be confusing without examples. So, the following is what it looks like with a real-life example.
Your financial institution offers an account that pays you an annual interest rate of 7%, which is compounded monthly for 10 years. You have $10,000 that you’d like to deposit.
Before you deposit your money, you want to make sure it’ll be worth it. Plug in the numbers into the formula to see how much you’ll have after ten years.
The following is what it looks like as an equation:
- P = $10,000
- r = 0.07, which is 7% as a decimal.
- n = 12 months in a year.
- t = 10 years.
A = 10,000 (1 + 0.07/12)^(12 x 10)
A = $20,096.61
In ten years, your money would’ve doubled. That’s the power of compound interest.
If you’d like to use a calculator instead of manually calculating the numbers, Investor.gov has one that’s easy to use.
Compound interest vs. simple interest
Compared to compound interest, simple interest is easier to calculate because it takes the principal amount, multiplies it by the annual interest rate as a decimal, and multiples that with the term in years.
The following is the formula for simple interest:
A = (P)(r)(n)
- A = The total amount of interest.
- P = The principal amount.
- r = The annual interest rate as a decimal.
- n = The term in years.
Using the same example from compound interest, the following is how much you’d earn if the interest was calculated as simple interest.
A = 10,000 x 0.07 x 10
A = $3,500
With simple interest, you would earn $3,500, which is about three times less than the $10,096.61 you earn with compound interest.
It’s the same annual interest rate, term, and principal amount. The biggest difference is that you earn interest on the interest you’ve already earned with compound interest.
If you had to choose between the two, which would you choose?
Compound interest, right? It’ll pay you more money in the same amount of time.
Where to find it?
Now that you understand what it is, and why it’s powerful, it’s time for you to take advantage of it.
Instead of paying it, you must earn it because it’ll help your money grow exponentially.
The following are the places and types of accounts that’ll pay you compound interest:
1. Certificate of Deposit (CD). A CD is considered a safe investment because it’s not tied to the stock market. It’s an account that financial institution’s offer, which pay a fixed interest rate for a time period.
For example, a financial institution may offer a 24-month CD with an interest rate of 3%. Every month you’ll earn interest, and as your balance increases with the interest deposits, the amount you’ll earn will grow.
2. High-yield savings account. A high-yield savings account is a deposit account offered by financial institutions. Generally, the annual interest rate will be higher than 1%, which is excellent compared to other savings accounts.
Most high-yield savings accounts will pay you interest once per month, and as your balance increases, the interest will increase as well.
3. Stocks and bonds. Stocks and bonds are two things that grow over time. The only downside is that stocks can fluctuate, which makes it more risky. Do your research and speak to a financial advisor before investing.
Frequently asked questions
Is compound interest good or bad?
If it’s working for you, and you’re earning money, then it’s good. However, if you’re paying it to a lender, it’s bad.
How long does compound interest take?
It depends on your financial institution. It may be compounded daily, weekly, monthly, annually, etc.
Can it double my money?
Absolutely. The time that it’ll take depends on how often it’s compounded, and with time, it’ll double your money.
When compound interest works in your favor, it’s an incredible way to earn interest. However, if your debt is compounding, you’ll want to pay it off as soon as you can. When it comes to earning interest, with time and consistency, it’ll build your wealth exponentially.
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Featured image courtesy of Pixabay.
About David Em
David Em is the founder of More Money More Choices, which he launched to help you take control of your finances and build your dream life. Before More Money More Choices, David worked in leadership positions in the finance industry.