Compound interest is a powerful force for people who want to build their savings. That’s why understanding how it works — and how to harness it — is very important.
Compound interest definition
When you deposit money in a savings account or a similar account, you’ll usually receive interest based on the amount that you deposited. For example, if you deposit $1,000 in an account that pays 1 percent annual interest, you’d get $10 in interest after a year.
Compound interest is interest that you earn on interest. So, in the above example, in year two, you’d earn 1 percent on $1,010, or $10.10 in interest payouts. Compound interest accelerates your interest earnings, helping your savings grow more quickly. As time passes, you’ll earn interest on ever-larger account balances that have grown with the help of interest earned in prior years. Over the long term, compound interest can cause your interest earnings to snowball very quickly and help you build wealth.
Many bank accounts, such as savings accounts and money market accounts, as well as investments, pay interest. As a saver or investor, you receive the interest payments on a set, pre-determined schedule, such as daily, monthly, quarterly or annually. And deposits in those accounts will compound the interest you earn, paying additional interest on interest you’ve already earned.
Depending on the account, interest can compound on different schedules. A basic savings account, for example, might compound interest daily, weekly, or monthly.
How does compound interest work?
It’s important to note that the schedule for compounding interest and paying out the interest may differ. For example, a savings account may pay interest monthly, but compound it daily. Each day, the bank will calculate your interest earnings based on the account balance, plus the interest that you’ve earned that it has not paid out.
The higher the interest rate of an account, and the more frequent the compounding, the more interest you will earn over a specified period of time. To illustrate how compounding works, we’ve included below the formula for compounding interest, as well as a few examples of how compounding affects earnings.
The formula for compound interest is:
Initial balance * (1 + (interest rate / number of compoundings per period) number of compoundings per period * number of periods
To see how the formula works, consider this example.
You have $100,000 in two different savings accounts, each paying 2 percent interest. One account compounds interest annually while the other compounds the interest daily. You wait one year and withdraw your money from both accounts.
From the first account, which compounds interest just once a year, you’ll receive:
$100,000 * (1 + (.02 / 1)1*1 = $102,000
From the second account, which compounds interest each day, you’ll receive:
$100,000 * (1 + (.02 / 365)365*1 = $102,020.08
Because the interest you earn each day in the second example also earns interest on the days that follow, you earn an extra $20.08 than you would in the account that compounds interest on an annual basis.
Over the long term, the impacts of compound interest become larger because you’re earning interest on larger account balances that resulted from years of earning interest on previous interest earnings. If you left your money in the account for thirty years, for example, the ending balances would look like this.
For annual compounding:
$100,000 * (1 + (.02 / 1)1*30 = $181,136.16
For daily compounding:
$100,000 * (1 + (.02 / 365)365*30 = $182,208.88
Over the 30-year period, compound interest did all the work for you. That initial $100,000 deposit nearly doubled. Depending on how frequently your money was compounding, your account balance grew to more than $181,000 or $182,000.
And daily compounding earned you an extra $1,072.72, or more than $35 per year.
The interest rate you earn on your money also has a major impact on the power of compounding. If the savings account paid 5 percent per year instead of 2 percent, the ending balances would look like:
|1 year||30 years|
The higher the interest rate, the greater the difference between ending balances based on the frequency of compounding.
Our compound interest calculator can help you calculate how much interest you’ll earn from different accounts.
How to take advantage of compound interest
There are a few ways that everyday people can take advantage of compound interest.
1. Save early
The power of compounding interest comes from time. The longer you leave your money in a savings account or invested in the market, the more interest it will accrue. The more time your money stays in the account, the more compounding can occur, meaning you get to earn additional interest on the earned interest.
Consider this example of someone who saves $10,000 per year for 10 years, and then stops saving, compared to someone who saves $2,500 per year for 40 years. Assuming both people earn 7 percent annual returns, compounded daily, they will have the following amount at the end of 40 years.
|Saves $10,000 per year for 10 years, then nothing for 30 years||Saves $2,500 per year for 40 years||Saves $5,000 per year for 40 years|
Both people save the same $100,000 overall amount, but the person who saved more earlier winds up with far more at the end of the 40 years. Even someone who saves $200,000, or twice as much over the full 40 years, winds up with less because they spread their savings over 40 years instead of doing most of their saving upfront.
2. Check the APY
The higher the interest rate of an account, the more interest you’ll earn from the money you put into an account and the more compound interest you’ll earn. While the simple interest rate is a good measure to use, annual percentage yield (APY) is a better metric to look at.
APY shows the effective interest rate of an account, including all of the compounding. If you put $1,000 in an account that pays 1 percent interest per year, you might wind up with more than $1,010 in the account after a year if the interest compounds more than annually.
If the account advertises a 1 percent APY, you’ll have exactly $1,010 in the account after a year passes because APY accounts for compounding.
Comparing the APY rather than the interest rate of two accounts will show which truly pays more interest.
3. Check the frequency of compounding
When comparing accounts, don’t just look at APY. Look at how frequently they compound interest. The more often they compound, the better. When comparing two accounts with the same interest rate, the one with more frequent compounding will have a higher APY, meaning it will pay more interest on the same account balance.