Compound Interest: Understand It & Use Its Power
Updated: June 14, 2020
If your goal is to build wealth, then you need to understand compound interest. This fundamental concept works for you if you save. However, compound interest can work against you if you borrow money. The same magic that allows your money to grow faster can speed up the growth of your debt.
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What Is Compound Interest and How It Works
Interest is the cost to use someone else’s money. Typically, you pay interest when you borrow money for a loan. Interest works in reverse too. The bank uses money deposited in your account to loan to other people; for this, they pay you interest.
Simple vs. Compound Interest
You can calculate interest in two ways.
- Simple interest is calculated from the principal (initial) amount only.
- Compound interest uses the principal plus the interest accumulated over the previous compounding periods. It is often called “interest on interest.”
Compounding Period and Compounding Frequency
With compound interest, you need to consider the compounding period and frequency.
- The compounding period is the duration between the current compound interest occurrence and the next one.
- The compounding frequency is how many times per year the interest is compounding. It may also be twice (bi-annual), four times (quarterly), 12 times (monthly), or some other frequency.
Good and Bad Sides of Compound Interest
Whether the power of compounding is good or bad depends on if it is currently working for or against you. Investments take advantage of the saving compounding rate, and this is good. When you borrow, you deal with the debt compounding rate, which costs you money. Take your credit cards as an example, which have a nominal APR (the stated interest rate). In reality, your credit card debt is compounded daily, and all the compounded interest adds up. Your actual interest rate will be higher than the nominal quoted one.
Understanding the Power of Compounding
Here’s a simple example. You decide to invest $1000 in an interest-bearing account with 5% interest compounded annually at the end of the year.
The first year, you earn 5% of $1000, which is $50.
The second year interest is generated on the new principal of $1050 (the initial investment plus the first year’s interest). You add $52.50 to your account in interest, raising your balance to $1102.50.
In the third year, the 5% interest rate is calculated with a principal of $1102.50.
This repeats in perpetuity until you close the account.
This example shows the power of compound interest. Each new interest calculation factors in the previously earned interest on the current principal. It’s interest upon interest. The best part is that you don’t have to do anything differently to get this benefit.
Compound Interest and Time Value of Money
There is one thing that makes compound interest more powerful: time. It has a more significant influence on compound interest than how much money you invest. This is why investing early is so important. When you invest in your teens or twenties, you give yourself extra time for compounding to work.
Consider three friends who started saving at different times in their life. They each invest $10,000 in similar accounts with a guaranteed 10% investment return that compounds at the year’s end.
- Tom began investing $10,000 per year at age 24 and stops at age 34. Over the ten years, he has invested $100,000.
- Richard started investing at age 34. He invests $10,000 annually until age 54 when he retires early. He has invested a total of $200,000.
- Henry also started investing $10,000 at age 24, until age 54. His total investment is $300,000.
At retirement, the account totals for each friend is given below.
Based on the results we see the following:
- Despite Richard saving for 10 more years than Tom, he has less than half the amount.
- Tom and Henry started saving at the same time, but Henry accumulated almost half a million more than Tom by retirement.
- Henry has almost three times as much in savings than Richard.
That is why it’s so important to start saving as soon as you can. There may be a lot of things fighting for priority in your financial life. Let savings be one of them. Even investing a little bit over a long period of time adds up due to the power of compounding.
How to Calculate Compound interest?
Compound Interest Calculator
There are a few different ways you can calculate compound interest. FinancialFreedom has an easy-to-use compound interest calculator. You select if you’re calculating the compounded amount or the opening balance, and choose the type of year. Then you enter the principal, compounding interest rate, and a total number of days in the compounding period. Lastly, you select the compounding frequency, and the calculator generates the results.
Compound Interest Formula
You may also use the compound interest formula:
A = P (1 + r/n) (nt)
- A = the future value
- P = the principal
- r = the compounding interest rate
- n = the number of compounding periods each year
- t = the time (years) that your money grows.
Let’s say that your principal is $1,000 with a 7% interest rate (0.07). The money is compounded monthly (12 times a year), and you’re planning to save for 10 years. Your future value, A, is calculated as follows.
A = $1000 (1 + 0.07/12) (12 x 10)
A = $1000 (1 + 0.07/12) (120)
A = $1000 x (2.00966) = $2,009.66
The Rule of 72
Use the Rule of 72 to estimate how long it will take for your principal to double using compound interest. All you need to do is divide 72 by the interest rate of your investment. If your investment has an 8% interest rate, the time to double it will be 72 ÷ 8, or 9 years.
Start Saving Now!
The best strategy to build wealth is to start saving as early as possible. It’s the cornerstone of the magic behind compounding interest and time value of money. Building wealth can be simplified to three things: save now, save early, and save consistently. Start on your journey to wealth by saving today.