While it initially sounds like a complicated concept, compound interest is the basic idea of earning interest on your interest. In more precise terms, earning interest on both your initial investment and the accumulated interest from previous periods.
Depending on how frequently this interest is calculated, this can be an incredibly valuable tool for investors. On the other hand, though, it can be devastating for anyone with significant debt – it can create a snowball effect that can be very difficult to overcome.
But whether you're just learning to invest, have been a dedicated saver for decades, or have suddenly found yourself under a mountain of debt – education is key. Our guide to compound interest will help you fully understand the concept and how it can both help and hinder you.
Key Takeaways
- Compound interest is when you earn interest on both your initial investment and the accumulated interest from previous periods. It's earning interest on interest.
- Simple interest is different – it only includes interest earned on a principal amount.
- There are formulas you can use to determine both compound and simple interest.
- The snowball effect of compound interest can negatively affect those with significant debt.
Compound interest calculator
Luckily, you don't have to do all of these calculations by hand. There are plenty of compound interest calculators online for you to take advantage of – including ours, which is right here:
Savings Info
You can use a calculator like this to determine how much your savings will increase with specific interest rates and regular contributions. It can be quite a handy tool when you're comparing interest rates and choosing between savings accounts.
Compound interest formula
Also called the periodic compounding formula, the compound interest formula looks like this:
C = p(1+r/n)nt
In this formula:
- C is the compound interest,
- p is the principal amount,
- r is the interest rate (as a decimal),
- n is the number of times the interest is compounded per year, and
- t is the time in years.
Let's look at an example to better understand how and when to use this formula. Shawn has $3,000 in a savings account that provides 3.5% interest. This is what his savings will look like in 5 years, assuming he doesn't contribute anything else to the account:
C = p(1+r/n)nt
C = 3,000(1+0.035/12)12*5
C = 3,572.83
So the result of our friend Shawn's responsible financial behaviour is a new balance of $3,572.83.
Formula for simple interest
Another formula to know is the simple interest formula, which looks like this:
S = (p * r * t)
In this case, the factors are as such:
- S is the simple interest,
- p is the principal,
- r is the interest rate as a percent (calculated annually), and
- t is the time in years.
Let's consider an example where we can use this formula. Let's say that Keri saves the same $3,000 as her friend Shawn, with that same 3.5% interest – but it's in an account that provides simple interest, not compound. Here's how much simple interest Keri would earn after 5 years:
S = (p * r * t)
S = (3,000*0.035*5)
S = 525
It looks like Keri's simple interest is $525 after 5 years, which makes the total amount saved $3,525. That's about $48 less than Shawn's earnings.
Simple vs. compound interest
Simple interest is based only on the principal amount. So what you earn in interest is not reinvested and therefore your balance doesn't increase quite as much. This type of interest is commonly used in car loans and personal loans.
Compound interest is the result of the interest earned on a savings balance itself earning interest. It's essentially money that's making money as your savings grow exponentially. However, the same is also true for debt, meaning that the interest on an amount that you owe will also multiply and the debt grows.
This type of interest is often used for savings accounts, investment accounts, and credit cards.
Wrapping your mind around the concept of interest can be tricky, but understanding the variables involved can help simplify things.
- Interest rate: This is the percentage at which the money grows or accrues annual interest. The higher this rate is, the more money you earn – or the more you owe.
- Principal: The principal amount is the initial amount of money that you're borrowing or investing. It's your starting point and a key factor in determining how much money you'll earn or owe.
- Compounding frequency: This refers to how often the interest is calculated and added to the principal. Common frequencies include annually, semi-annually, quarterly, monthly, or daily.
- Duration: The length of time the money is invested or borrowed is usually expressed in years. The longer you leave your funds in a savings account, or the longer you hold onto a specific debt, the more time it has to compound.
The table below breaks down how these different types of interest affect your investments in different ways. The initial investment for this example is $15,000 and the interest rate is 4.5%.
| Year | Simple interest earned | Simple interest total | Compound interest earned | Compound interest total | Difference |
|---|---|---|---|---|---|
| 1 | $675 | $15,675 | $675 | $15,675 | $0 |
| 2 | $1,350 | $16,350 | $1,380 | $16,380 | $30 |
| 3 | $2,025 | $17,025 | $2,117 | $17,117 | $92 |
| 4 | $2,700 | $17,700 | $2,888 | $17,888 | $188 |
| 5 | $3,375 | $18,375 | $3,693 | $18,693 | $318 |
| 10 | $6,750 | $21,750 | $8,295 | $23,295 | $1,545 |
| 25 | $16,875 | $31,875 | $30,082 | $45,082 | $13,207 |
Maximizing the benefits of compound interest
Making compound interest work to your benefit isn't as difficult as you might think: starting as early as possible with your investments is an all but surefire way to take advantage of this kind of interest. As with most investment planning, taking the time to educate yourself and consider your options can really pay off.
Here are a few tips to keep in mind:
- Start early – the earlier you begin investing, the more time compound growth is possible. Time is your friend.
- Check the rate of compounding. Opt for accounts with more frequent compounding periods, like monthly or daily rather than annually. The higher the frequency, the more you earn.
- Make regular contributions, even if they're small. The more you have invested, the more growth is possible.
- Don't withdraw money. The higher the amount invested, the more compound interest is earned, and withdrawing leaves you with less to compound.
- Choose accounts with high interest rates. Yes, this seems obvious, but it's also important. A low interest rate isn't going to help you much at all.
How compound interest affects debt
Unfortunately, compound interest can increase your debt just as quickly and easily as it can increase your investments. The interest you pay annually to manage your existing debt can accumulate over the years, eventually totaling much more than your original debt amount.
But there are, luckily, actions you can take to manage your debts, pay down what you owe, and avoid the snowball effect. Here are a few strategies that can help:
- Make more than the minimum required payment. Whether it's your credit card, a line of credit, or something else entirely, making bigger payments will have more of an impact on your debt – even if it's just a little bit more than the minimum requirement.
- Use the "avalanche" approach to rank your debts. This way you can identify which has the highest interest and make it the first one to pay down.
- Consider consolidating your debts. You'll likely get a lower interest rate this way and more favourable repayment conditions.
- Apply for a balance transfer credit card if most of your debt is from credit cards. Sometimes you can get promo offers of 0% interest for a certain amount of time – take this time to aggressively pay it down.
- Regularly review and adjust your plan to ensure that you're staying on track.
Pros and cons of compound interest
The truth is, compound interest is a double-edged sword with both pros and cons to consider. The benefits are big, helping to increase your wealth and make your life easier – but the drawbacks are also big, causing your debt to grow exponentially.
Here's an overview of the most important pros and cons to be aware of:
| Pros | Cons |
|---|---|
|
|
What it boils down to is whether you're concerned with your investments or your debts. Compound interest is a huge benefit for your savings, but a scary disadvantage for your loans.
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Are you taking advantage of compound interest?
If you have any type of savings or investments, it's important to understand how to make compound interest work to your advantage. And acting sooner rather than later is equally as important.
Do you take advantage of compound interest? Do you have any tips for those who don't fully know how to make it work for them?
Feel free to share your thoughts and experiences with us in the comments section below.
FAQ
What is compound interest?
Compound interest is the interest earned on your interest. It's the interest on the principal amount invested and the interest earned on that interest. It can also be applied to debt; the interest on the principal owing also earns interest.
Can you tell me how to calculate compound interest?
There's a formula you can use to calculate compound interest: C = p(1+r/n)nt. This uses the principal amount in question, the interest rate, the frequency of compounding (times per year), and the number of years in question.
What is the difference between simple interest and compound interest?
Simple interest is only earned on the original amount, while compound interest is earned on both the original amount and any interest already accumulated. Compound interest grows faster due to this added interest on interest.
What is the formula for compound interest?
The formula is: C = p(1+r/n)nt. To figure this out, you'll need to know the principal amount invested, the interest rate, the frequency of compounding, and the length of time being considered.
What is a compound interest loan?
A compound interest loan is one where interest is calculated not just on the principal amount, but also on the accumulated interest from previous periods. This leads to an increasing total amount owed over time.
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