How Compound Interest Works

Compound interest is a powerful financial tool that if used to one’s advantage, can generate lucrative benefits over time. The nature of compound interest is that previously earned interest income gets added to a savings account balance and subsequently earns interest income on top of it, thereby compounding. However, the reverse is also true.

Outstanding debt balances also compound, but in this instance it’s interest expense that compounds on top of a debt balance already owed, and the process of repayment and getting out of debt becomes slower. For those individuals making minimum monthly payments on high interest rate credit cards, for example, it can take many years longer and several thousand dollars of compound interest expense later before a debt is fully repaid. Let’s take a closer look at both the virtues and perils of compound interest.

Compound Interest is an important concept to understand. Over time, it can make the difference between generating wealth or merely treading water financially. Let’s take a hypothetical example of $10,000 in a savings account that earns interest at 5% a year. (Not a real-world example as of December 2018) The simple interest income generated after one year would amount to $500.

However, in year two, compounding begins, as the first year of interest income brings the new account balance to $10,500, which is still earning 5% interest per year, and this results in interest income of $525 in the second year. The extra $25 in interest income that second year may not sound like much, but the principle of compound interest has now been activated, and with each passing year, the compounding increases. All of the interest income that was generated in previous years continues to earn 5%, and the cycle of wealth generation is in motion.

With compound interest, time is on your side. If at all possible, begin the process of depositing into a savings account at an early age and have a long-term view. Understand that compounding starts slowly, but that positive momentum becomes inevitable. Making money through the principle of compound interest can become a form of passive income that pays dividends throughout a lifetime.

Though a low interest rate environment has persisted in the United States since the days of the financial crisis, this hasn’t always been the case historically and likely won’t always be the case in the future. Banks advertise interest rates as APYs (annual percentage yields) that take into consideration the principle of compound interest and are therefore somewhat higher than the stated annual interest rate.

It is important to recognize that the principle of compound interest works in reverse when it comes to debt. When debt balances are accumulated and not paid off, the interest expense that accumulates on the outstanding balance will compound – and this can lead to a vicious cycle of interest expense generating more interest expense.

Worse still, interest rates on debt will almost always be higher than those that come with savings accounts. Though it may sound obvious, it is therefore important to pay off debts quickly and to keep borrowing rates as low as possible.

For those already burdened with high debt levels, it can make sense to pursue debt consolidation or a debt management plan to achieve a lower blended interest rate that will reduce the negative effects that result from compound interest expense on existing debt.

The principle of compound interest is completely unaffected by the amount of money invested. When two different accounts start with $100 and $10,000, the percentages earned on either initial deposit are of identical proportion over time, assuming the two accounts are earning the same annual percentage yield. However, pay attention to the frequency of compounding – in other words, how often does the account compound? Savings accounts and CDs that calculate the compounding daily – as opposed to monthly or annually – will earn interest income faster – so look for this when opening an account. Unfortunately, in the case of credit cards, it isn’t too difficult to find those that do compound daily – they are very common. Understand that in either instance, daily compounding does not imply that the full interest rate is earned each day, but rather, 1/365 of what would be the annual simple interest earned (or charged) on the existing balance is added each day.

The Rule of 72 is a nifty tool that allows for the calculation of how many years it will take for an amount of money to double through the principle of compound interest given a specific interest rate. Here’s how to use it: Take the number 72 and divide it by the interest rate – the result will be the number of years it takes for the balance to double.

For example, an interest rate of 9% will lead to a balance doubling in eight years, since 72 divided by 9 is eight. Similarly, an interest rate of 6% will double a balance in twelve years, since 72 divided by 6 is twelve. For other calculations designed to illustrate the power of compound interest, it can be useful to practice with an online compound interest calculator.

Related:

• Interest Rates
• Credit Card Interest – Tax Deductable?