Key Takeaways
When it comes to having an accurate snapshot of your finances, compound interest is bound to be mentioned at some point or another. Especially for real estate investors that have potentially taken out numerous loans to assist in property business traffic, compound interest is a topic that should be well understood. Compound interest is a double-edged sword. It can be your best friend or your worst enemy, depending on your situation.
If you’ve found yourself asking, “How does compound interest work?” then you’ve come to the right place. It’s something that you should know about, whether you’re an everyday consumer or a seasoned investor seeking more insight regarding the state of your investments. In this article, Fortune Builders will explore what compound interest is, how compound interest works, as well as some of the financial choices that can be made to use compound interest to your advantage. By having a firm grasp of the benefits of compound interest, you’ll be on your way to a more prosperous future.
What Is Compound Interest?
Compounding is the process of growing something exponentially. With that in mind, you can think of compound interest as interest that builds upon itself. Compound interest happens when interest is added to the principal amount that is either invested or borrowed, which repeats upon the new value during the next compounding period. For this reason, it’s fairly common for compound interest to be described as “interest on interest” as it represents the interest on a deposit or loan that grows over time. The rate that compound interest grows varies based on the frequency of compounding. So the higher the number of compound periods, the greater the compound interest will become.
It’s important to understand that compound interest is neither good nor bad, it’s all about how it is leveraged within a financial decision. It’s important for borrowers to keep an eye on compound interest to not get boggled by debt, but for investors, it can be a way to maximize profits tremendously.
How Does Compound Interest Work?
Now that we understand what compound interest is, let’s dive deeper into how you’d get compound interest. It’s best to show you how compound interest works through a real example.
Let’s say you put $5,000 into a savings account. This savings account provides a 2% interest rate that compounds annually. At the end of year one, you’ll have $5,100. This is your principal of $5,000, plus $100 in interest earnings. It’s after the second year that you see compound interest starting to kick in. At the end of year two, your new savings total will total $5,502 due to compound interest.
This means that your interest earnings are compounded from $100 to $202 in two years, but let’s take the example further. By year 10, your initial principal of $5,000 will turn into a savings of $6,094.97. Thanks to compound interest, your savings will have grown over $1,000 without you pouring additional funds into the account at all.
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How To Calculate Compound Interest
Compound interest is your total principal plus its future value, minus its present value. It’s calculated by taking the initial principal and multiplying it by one plus the annual interest rate, raised to the number of compound periods minus one. This sounds complicated, but is much easier to understand how compound interest works by looking at the formula:
Compound Interest = P[(1+r)^n – 1]
In this formula, the “P” represents the total principal, the “r” represents the interest rate, and the “n” represents your number of compound periods. Let’s take our example regarding the savings account to show how this formula works.
In this case, “P” is $5,000 (your initial principal), “r” is .02 (2% interest rate expressed as a decimal), and “n” is 10 (annual compound periods of 10.)
Compound Interest = P[(1+ r)^n – 1]
Compound Interest = $5,000 [(1+.02)^10 – 1]
Compound Interest = $5,000 [1.21899 – 1]
Compound Interest = $5,000 [0.21899]
Compound Interest = $1094.97
Using the formula, we calculated that in 10 years, you will earn $1,094.97 in compound interest. Your total savings will be $6,094.97 (add the $1,094.97 interest to the $5,000 principal amount.)
If you’re interested in calculating the total savings amount including the compound interest, there’s another formula you can use:
A = P(1+ r/n)^nt
In this case, “A” represents the total savings, “P” still represents the principal, and “r” still represents the annual interest rate. What’s a little different in this formula from the previous one are the variables “n” and “t.” In this case, “t” represents your time horizon, and “n” represents the number of times the interest compounds each year.
Let’s apply this formula using the same example as above.
A = P(1+ r/n)^nt
A = $5000(1+ 0.2/1)^(1*10)
A = $5000(1.02^10)
A = $6,094.97
As we derived in the previous examples, the resulting savings, including compounded interest, is $6,094.97.
In summary, these two formulas help you calculate either the compounded interest amount or the total savings, including the compounded interest. These formulas are pretty simple and easy to calculate, but it’s completely understandable if you have trouble committing both of these to memory. Instead, you can use a free online calculator, like this one offered by Moneychimp.com.
Compound Interest Growth
In our example above, the accumulated interest was just $100 after one year. After 10 years, however, the accumulated interest was a whopping $1,095. For investors looking to maximize profits or even someone who seeks to save money over time for a major financial maneuver, compound interest is quite the wealth-building powerhouse.
The best part is that you can put money into an account and forget about it. The compound interest will do its own work overtime without any level of intervention or strict monitoring. Of course, you can build wealth even faster by adding to your principal amount at regular intervals. Bankrate.com provides an annual list of the best savings accounts with high yield interest rates to help investors take advantage of compounding interest.
Compound Interest & Debt
As we discussed, there are many benefits to compound interest if you’re on the right side of the loan. Compound interest can be your best friend when you’re growing your savings, but it can also be a double-edged sword. This is because compound interest can be your worst enemy if you’re borrowing instead of saving. If you check out the interest rates on high-yield accounts, you’ll notice that they range between 0.6% and 0.8% at best.
On the flip side, the interest rate on a personal loan can easily be upwards of 20%, depending on the principal loan amount and your credit score. (You can take a look at example loan rates on Bankrate.com.) Here, you should notice that interest rates for loans are much higher than those for savings accounts. If compound interest helps savings accounts grow quickly, can you imagine how much more quickly debt will grow for borrowers?
Compound interest’s rate of growth can happen swiftly and can be damaging to your financial health. Living beyond your means is an easy way to get into debt quickly, especially when that debt grows exponentially and continues to get charged interest over time. That’s why you should always strive to pay off your debts as soon as you can and avoid compounding interest in scenarios of a large initial principle, such as student loans or mortgages.
What Is The Difference Between Simple & Compound Interest
The major component of understanding compound interest is its common confusion with simple interest, but these terms should never be used interchangeably. Simple interest is calculated using only the principal amount, the initial size of the loan or deposit. In the case of compound interest, both the initial principal and the previously accumulated interest are considered. Thus, compounded interest grows much faster than simple interest because it will always be accrued based on the ever-growing value of the loan’s interest. Some investors call compound interest the “money snowball effect” because it can lead to exponential growth for your money.
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Understanding The Benefits Of Compound Interest
Now that we’ve gone over how compound interest can be used to your advantage or be within a situation that could be seen as a disadvantage, let’s focus on the fun stuff. There are numerous strategies you can implement so that when compound interest is on your side, you can maximize its benefits. Some effective choices you can make as an investor with compound interest include:
Save Early
The benefit of compound interest increases over time, so it’s important to start saving early. As shown in the examples earlier on, you should have noticed that the total savings were much higher in year 10 than the first couple of years. If you can, make additional deposits as often as possible. You’ll be pleasantly surprised to see just how quickly your money will grow, thanks to compounding.
Compare interest rates
As a consumer, you should always shop around before committing to a product. Be sure to research different types of savings and investment accounts and their associated interest rates. How can you tell if the rate shown is an interest rate or a compound interest rate? Look for the term “APY,” which stands for annual percentage yield. You can start by comparing the rates of savings accounts and CDs provided by your bank, and then consider switching banks if you find one that offers a significantly higher rate.
Pay off your debts as soon as possible
If you have credit cards and loans, it’s in your best interest to pay them off as soon as possible. Paying just the minimum on these accounts will barely make a dent. You’ll find that you’ll accumulate interest faster than you can pay down your principal. One of the most common types of loans is student loans. Although it’s understandable if you can’t start repaying your student loans before you graduate, a smart move would be to pay down any accrued interest. This way, you can at least avoid interest charge capitalization and get a head start in paying down your balance. Also, if you focus on paying off your debts first and foremost, you’ll free up some cash flow that you can put toward your savings.
If you must borrow, keep the rate low
There will likely be times in your life where you’ll be forced to take out a loan. This could be for a car purchase, a home loan, or even an unforeseen emergency. Be a smart consumer by comparing products and interest rates. After all, the interest rate is what determines how quickly your debt will grow. If you have outstanding credit card debts, find out if there is a way you can consolidate your debt into one lower interest rate.
Summary
Understanding what compound interest is can ultimately come down to the nature of how the principle originated. If you have more debts than savings, then compounding interest can feel scary. Those concerned with paying down their debt have likely asked themselves, “how does compound interest work?” to better understand the best ways to manage compound interest. Once you realize how significantly compound interest grows your debt, you’ll be incentivized to get rid of that debt as soon as possible.
As you pay off debt, you’ll be freeing up more of your money so that you can start saving and building your wealth. If you need some help getting out of debt quickly, check out our guide on using the debt snowball method. As soon as you start enjoying the benefits of compound interest, and instead view compound interest as an opportunity for potential profit, you’ll be thanking yourself.
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