When you deposit money into a savings, money market or other type of deposit account, you may earn interest — a percentage of the account balance paid to you periodically by the financial institution for allowing them to use your money. When you take out a loan or take on credit card debt, interest works the other way: You periodically pay the financial institution a percentage of your outstanding balance for the privilege of using their money.
Compound interest is interest calculated on an account’s principal plus any accumulated interest. If you were to deposit $1,000 into an account with a 2% annual interest rate, you would earn $20 ($1,000 x .02) in interest the first year. Assuming the bank compounds interest annually, you would earn $20.40 ($1,020 x .02) the second year. (Most banks compound interest much more frequently; we chose annual compounding to simplify this example.)
Simple interest, on the other hand, is calculated on principal only. If you were paid simple interest on the account above, you would earn the same $20 interest a year rather than reaping the rewards of compounding. When interest is based on your growing balance, your funds can snowball over time.
In the case of money you borrow, compounding can work against you. When interest is charged on credit card accounts or loans that use compounding, that interest is calculated based on your principal plus any interest previously accrued on your account. You may end up paying more or needing more time to pay off your balance.
To gain better insight into how much compounding interest can affect what you earn or pay, take a look at how it’s calculated.
How Compound Interest Is Calculated
Whether it is interest you will earn or interest you will pay, compound interest can be calculated using the following formula:
x = P (1+r/n)nt - P
x = compound interest
P = principal (the initial deposit or loan amount)
r = annual interest rate
n = the number of compounding periods per unit of time
t = the number of time units the money is invested or borrowed for
Let’s use an example where you earn interest. Say you deposit $5,000 into a savings account at an annual interest rate of 5%, which is compounded monthly. That deposit would earn $3,235.05 in interest at the end of 10 years. Here’s a breakdown of the math:
x = P (1+r/n)nt - P
x = 5,000 (1+.05/12)12x10 - 5,000
x = 5,000 (1.00416667)120 - 5,000
x = 5,000 (1.64701015) - 5,000
x = 8,235.05 - 5,000
x = 3,235.05
Over that 10-year period, your deposit would grow from $5,000 to $8,235. The same account earning simple interest would grow to only $7,500.
Of course, if you don’t enjoy crunching numbers, you can use an online calculator. Calculators can be particularly helpful when you are regularly making deposits or payments to your accounts, since your balance will be changing as you go.
The frequency of compounding is particularly important to these calculations, because the higher the number of compounding periods, the greater the compound interest. And while interest can be compounded at any frequency determined by a financial institution, the compounding schedule for savings and money market accounts at banks are often daily. The interest on certificates of deposit (CDs) may be compounded daily, monthly or semiannually. For credit cards, compounding often takes place monthly or even daily. More frequent compounding is beneficial to you when you are the investor, but it’s a disadvantage when you are the borrower.
How Compound Interest Can Affect Your Financial Planning
Given that compound interest can be beneficial (when you’re the investor) or disadvantageous (when you’re the borrower), it’s important to consider its potential in your financial plans.
To fully reap the rewards of compound interest, save! Choose deposit and investment accounts that offer compounding interest, and do your best not to make withdrawals so that interest has a chance to really add up.
To avoid paying compound interest, shop for loans that charge simple interest. Many large loans — mortgages and car loans, for example — do use a simple interest formula. By contrast, credit cards and some other loans frequently use compound interest. So use credit cards wisely and be sure to pay off your statement balances every month.
As you become more familiar with compounding interest, you will be able to leverage it to your advantage as you build your wealth and minimize your debt.