How Does Compound Interest Work to Grow Your Money?
Banking accounts, credit cards, student loans, mortgages, personal loans—each uses compound interest. To manage your personal finances successfully, it helps to have a basic understanding of compound interest and how it can work to grow your money.
So, how does compound interest work? It turns out it’s not that complicated―and you can use it to your advantage to make the most of the money you’ve got.
First: a quick review of simple interest
Let’s start with some important terms: The amount of money you put into an interest-bearing account or investment is called “principal.” So, if you deposit $1,000 of your own money into a savings account, that $1,000 is your principal amount. Any money you earn on top of that $1,000 is what’s known as “interest.”
Now, to understand compound interest, it helps to understand something called “simple interest.” Simple interest is interest earned only on your principal. So, if you earn simple interest on $1,000 at an annual interest rate of 5% per year, you’ll receive 5% interest (that’s $50 of extra money) every single year. However, compound interest works differently.
How does compound interest work?
Compound interest occurs when interest is added to the original investment (the principal), and on the full balance of your account, including any interest that has accrued since you invested the principal. So, it's essentially interest on interest which over time leads to exponential growth.
To further illustrate how compound interest works, suppose you put $1,000 principal into an account that earns 5% compound interest each year. So, one year from now, you’ll have $1,000 plus 5% of $1,000, which is $50. In total, you’ll have $1,050 after the first year.
So far, this example is identical to our simple interest scenario, but here’s where the compounding comes into play. At the end of the second year, you won’t simply earn another $50 in interest. Instead, your account will earn 5% of $1,050, which is $52.50. In total, you’ll have $1,102.50.
The table below shows how much money you’ll have after making that one-time deposit of $1000 after 10 years.
The power of compound interest
As you can see, compounding interest is a powerful tool to build wealth and reach your financial goals. Your original deposit and the amount of interest grows exponentially over time as the dollar amount that constitutes 5% grows, and your rate of return is much higher.
Want to play around with your own interest calculations? Try using a compound interest calculator like this one from FinancialMentor.
How to take advantage of compound interest
Obviously, stashing your money in an interest-bearing account earns you more money than you would get by stuffing it in your mattress. But what can you do to maximize the power of compounding interest?
1. Start saving early.
When it comes to interest, your greatest ally is time. In the example above, see how much more interest you earn if you’re willing to save for 10 years instead of just one? If you’re saving money for long-term goals—like not having to work as much when you’re older—your best bet is to start saving as soon as possible. The earlier you start, the more time your money will have to grow.
2. Up your savings game.
If time is the most important factor in earning interest, then the actual total amount of dollar bills are a close second. Simply put: the more money you save, the more interest you’ll get. This is a financial health tip that might seem obvious but worth pointing out.
So, make saving a priority in your life, and keep it that way. Putting away a bit here and a bit there will add up over time, especially as your nest egg accumulates more interest over compounding periods.
3. Choose your accounts and investments wisely.
The interest rate you’re getting on your savings plays a huge role in how quickly your cash will grow over a period of time. With this in mind, it pays to make sure you’re getting the best deal before you even start.
If you’ve been with your bank for a while, do some comparison shopping. What interest rates are other banks or credit unions offering on their savings accounts? If some or all of your money is sitting in a zero-interest checking account, look for a financial institution that offers checking with interest.
If your money is invested in the market, check in regularly to see how your assets are performing, and don’t get sucked in by the promise of sky-high returns. Make sure you’re striking a balance between your money’s potential growth and your tolerance for risk.
4. Knock down your debt.
Unfortunately, compound interest isn’t always your friend. When you have debt, compound interest works against you. Each month you carry a credit card, personal loans and personal loan taxes, or other unpaid balance, you’ll owe the amount you’ve charged and the unpaid interest you’ve accumulated, as well.
Your best bet is to get proactive about paying down debt faster. Pay more than your minimums and embrace a proven debt reduction strategy. Explore your options for reducing the interest rate on your debt. Jean Chatzky’s advice on negotiating with your creditors might be a good place to start. A lower rate means you’ll owe less money and get out of debt quicker.
When it comes to compound interest, there’s no financial sleight of hand, just regular financial checkups. The magic happens when you make the effort to save what you can and reduce what you owe. Now that you understand what is compound interest and how it can work to grow your money, you're on your way to taking control of your financial health.