Often referred to as the “eighth wonder of the world,” compounding interest lets your money work for you.
What is compound interest?
Compound interest is the interest on a deposit calculated based on both the initial principal and the accumulated interest from previous periods.1 Or, more simply put, compound interest is interest you earn on interest . You can compound interest on different frequency schedules such as daily, monthly or annually.
The higher the number of compounding periods, the greater the compounded interest. Think about it like a snowball. The sooner you start saving, and the more money you add to your snowball, the larger it will grow. Now, think about if you pushed the snowball down a snow-covered hill. Now the snow you already packed will stay, and you’ll accumulate more snow. Eventually, when your snowball reaches the bottom of the hill, it will contain the snow you started with, the snow it picked up along the way, and even more snow on top of that.
In other words, the interest-on-interest effect can generate continually increasing returns based on your initial investment amount. So, the more frequently you save, and the larger the amount you save, will return larger amounts of interest. This is also called “the miracle of compound interest.”
Why is compound interest important?
Compound interest causes your wealth to grow faster. It makes a sum of money grow at a faster rate than simple interest because you will earn returns on the money you invest, as well as on returns at the end of every compounding period. This means that you don’t have to put away as much money to reach your goals!
The magic of compounding can be an important factor when building your wealth. The earlier you open an interest-bearing account and start stocking away money, the more money you will earn in compound interest. It’s also key to helping mitigate wealth-eroding factors like the rising cost of living, inflation, and reduction of purchasing power.
How to calculate compound interest:
Compound interest is calculated by multiplying the initial principal amount by one, plus the annual interest rate, raised to the number of compound periods, minus one.
When calculating compound interest, the number of compounding periods makes a significant difference. The higher the number of compounding periods, the greater the compound interest.
Make it easy - use this calculator to calculate compound interest!
Be sure to consult with your tax advisor or financial advisor on the best way for you to get started. As always, we are here to help! Contact us or visit your local Central Bank with any questions.
Sources:
1Compound Interest, Investopedia
FAQs
Compound interest is when you earn interest on the money you've saved and on the interest you earn along the way. Here's an example to help explain compound interest. Increasing the compounding frequency, finding a higher interest rate, and adding to your principal amount are ways to help your savings grow even faster.
What is a compound interest in simple terms? ›
Compound interest is interest that applies not only to the initial principal of an investment or a loan, but also to the accumulated interest from previous periods. In other words, compound interest involves earning, or owing, interest on your interest.
What is compounding and why is it important to investing? ›
Compounding is a powerful investing concept that involves earning returns on both your original investment and on returns you received previously. For compounding to work, you need to reinvest your returns back into your account. For example, you invest $1,000 and earn a 6% rate of return.
Why is it important to learn simple and compound interest? ›
When it comes to investing, compound interest is better since it allows funds to grow at a faster rate than they would in an account with a simple interest rate. Compound interest comes into play when you're calculating the annual percentage yield. That's the annual rate of return or the annual cost of borrowing money.
What are the benefits of compound interest in investing? ›
The main advantage of compounding is that it allows the reinvestment of earned interest or investment gains, leading to higher growth. Over time, the returns earned from investments generate additional returns, which compound and further increase the growth of the investment.
How do you explain compound interest with examples? ›
For example, if you deposit $1,000 in an account that pays 1 percent annual interest, you'd earn $10 in interest after a year. Thanks to compound interest, in Year Two you'd earn 1 percent on $1,010 — the principal plus the interest, or $10.10 in interest payouts for the year.
How do you explain compound interest to a child? ›
Put simply, compound interest is when you earn interest on both the money you've saved and the interest you've already earned.
What is the miracle of compound interest? ›
Compounding is the process whereby interest is credited to an existing principal amount as well as to interest already paid. Compounding thus can be construed as interest on interest—the effect of which is to magnify returns to interest over time, the so-called “miracle of compounding.”
What is the magic of compound interest? ›
Compound interest accelerates the growth of your savings and investments over time. Conversely, it also expands the debt balances you owe over time.
How is compound interest used in everyday life? ›
Compound interest is widely used in various financial products and investments, such as savings accounts, bonds, loans, mortgages, and investment portfolios. Understanding compound interest is crucial for making informed financial decisions and planning for the future.
Answer: Compound interest allows your wealth to grow more quickly. It enables an amount of money to grow faster than simple interest since you'll earn returns on the capital you put in and yield after each compounding time. The power of compounding could be a key factor in creating wealth.
What are the advantages and disadvantages of compound interest? ›
Understanding the advantages and disadvantages of compound interest is crucial for making informed financial decisions. Compound interest can be a powerful tool for wealth accumulation and investment growth, but it can also lead to higher debt burdens and increased interest costs.
Is compound interest always beneficial? ›
Student loans: Compound interest doesn't always benefit the consumer; it works against you when you take out loans or credit cards. This includes student loans. While all federal student loans accrue simple interest, some private loan issuers charge interest that compounds annually, monthly, or even daily.
Who does compound interest favor? ›
If you're paying interest on debts like credit cards, student loans, or a car loan, allowing balances to accrue over time rather than paying them off can cost you more in interest charges over time. If you're earning interest — on something like a high-yield savings account — compound growth can work in your favor.
Is compound interest always good? ›
Compound interest is great when it works in your favor in investments, but it can also be your biggest enemy when it works against you in loans and other debts. The key is to figure out how you can let it work in your favor.
How much is $1000 worth at the end of 2 years if the interest rate of 6% is compound? ›
Basic compound interest
For other compounding frequencies (such as monthly, weekly, or daily), prospective depositors should refer to the formula below. Hence, if a two-year savings account containing $1,000 pays a 6% interest rate compounded daily, it will grow to $1,127.49 at the end of two years.
How is compound and simple interest different? ›
Unlike simple interest, which only earns on the principal amount invested, compound interest earns both on the principal and on the accumulated interest of previous periods. As a result, investors who take advantage of compound interest can see their money grow faster compared to those who don't.
What is a compound interest in real life? ›
Answer: Compound interest allows your wealth to grow more quickly. It enables an amount of money to grow faster than simple interest since you'll earn returns on the capital you put in and yield after each compounding time. The power of compounding could be a key factor in creating wealth.
What is compound interest and how do you earn it? ›
Compound interest is the interest you get on: the money you initially deposited, called the principal. The original sum of money invested, or the amount borrowed or still owing on a loan. the interest you've already earned.
