can be one of the most beneficial or damaging things to your wallet. And it all depends on whether you earn it or pay it.
When you earn compound interest, you could end up with a much larger balance than you originally invested. But when you’re charged compound interest, you could end up paying a lot more than you’ve ever borrowed.
But what is compound interest anyway? How does it work and how does it differ from simple interest? We will take a look.
What is compound interest?
Compound interest is the process of adding interest to a principal amount and basing future interest on that new balance. This is how it works.
Imagine investing $ 100,000 in the stock market and in the first year you got a 10% return. This would represent a growth of $ 10,000, which would bring the overall value of your portfolio to $ 110,000.
Then in the second year you earn an additional 10%. But remember, you are now earning 10% of $ 110,000 instead of $ 100,000. So you would actually win $ 11,000 in interest the second year, bringing the value of your account to $ 121,000.
It may not seem like a big difference. But compound interest continues to gain momentum over time. Each year, you would earn a little more interest on a slightly larger balance. In fact, with an annual return of 10%, compound interest would help your account grow to over $ 1 million in just 25 years.
And this without any additional contribution during the entire 25-year period.
How compound interest compares to simple interest
Now let’s take the same example above and imagine you got paid with simple interest instead.
If you earned 10% simple interest, you would earn $ 10,000 each year for 25 years – you would never earn interest except on your primary investment.
So, over 25 years, you would earn $ 225,000 in simple interest. After you add this to your initial balance of $ 100,000, you will find that your final balance is $ 350,000.
That’s over $ 650,000 less than what you would have had your interest compounded throughout the process.
Fortunately, most investments use compound interest. On the other hand, simple interest is most often used for installment loans, such as mortgages and auto loans.
This is generally good news. But there are situations where you might have to pay compound interest on the debt, which we’ll talk about later.
How often is interest compounded?
The amount you earn (or pay) with compound interest is heavily influenced by the frequency of compounding.
When you compare CDs or high yield savings accounts, for example, you may see a variety of compounding schedules, such as daily, monthly, or semi-annual.
The more frequent the schedule, the more compound interest you will earn over time. So an investment product with a slightly lower interest rate could still be more valuable to you over time if the compounding schedule is more frequent.
To help you determine the true value of compound interest over time, you’ll need a way to calculate it. We will then discuss how to proceed.
How to calculate compound interest
Not a math fan? Its good.
You don’t have to calculate compound interest with pen and paper. There are many tools available that can help you calculate compound interest in seconds.
For example, Investor.gov has a simple and easy to use compound interest calculator. Simply enter your principal balance, estimated interest rate and term, and the compound interest calculator can show you immediate results.
Do you plan to continue making regular contributions over time? The compound interest calculator can also take this into account.
The compound interest formula
If you’re ambitious and want to do the math yourself, here’s the compound interest formula:
FV = PV x (1 + i) n
In this formula, VF means future value, PV means current value, I denotes the interest rate, and m denotes the number of compounding periods.
So suppose you want to calculate your compound interest income on a $ 10,000 investment earning 5% compound interest annually over five years. Here’s how that would be expressed in the formula above.
- VF = $ 10,000 x (1 +0.05) 5
- VF = $ 10,000 x 1.055
- VF = $ 10,000 x 1.2762
- VF = $ 12,762.00
Another quick way to calculate your compound interest return is to use the rule of 72. This rule shows you how quickly you can expect your investment to double over time.
It’s easy to use the rule of 72. Just divide the number 72 by your expected interest rate. So if 6% was your expected rate of return, you can reasonably expect your investment to double every 12 years (72 divided by 6 = 12).
How to Avoid Paying Compound Interest
Earning compound interest is great. But paying compound interest is anything but. In fact, it can have disastrous effects on your finances.
As mentioned earlier, most large loans, like auto loans and mortgages, use simple interest formulas. However, there is one type of debt that uses compound interest: credit cards.
Most credit card issuers compound interest daily. This interest will start accruing the day you make a purchase with your credit card.
However, the good news is that most credit card issuers will give you a grace period until your due date. In other words, if you pay your statement balance in full before the due date, they will waive the interest charge. But interest will be assessed on any part of the unpaid balance.
So if you don’t want to pay compound interest, you’ll want to avoid carrying a credit card balance past your due date whenever possible.