What Is Compound Interest and Why Does It Matter?
Compound interest might sound confusing if you’re never heard of it before. It plays a role when we invest, take out loans and save money.
In a nutshell, compound interest is the interest of the interest.
Say that one year you earn 10% interest on a $1,000 investment. Now you have $1,100 and have earned $100 in interest.
The following year, you earn another 10% interest. This time you already have $1,100, so you earn $110 in interest – $10 more than last year.
This is the compounding effect, which Albert Einstien called the 8th wonder of the world.
3 Ways You’re Affected By Compound Interest:
- Investing – When you invest your money, you do so with the expectation that your money will grow. The sooner you start investing, the more interest your investments will accumulate.
- Saving – Today, you don’t get much interest on savings accounts, but even small percentages add up in the long run.
- Borrowing – Compound interest can also work against you, for example when you take out a loan. If you don’t pay back on time, the interest will accumulate via the compounding effect, and you will have to pay back more money than originally.
Compound interest allows you to earn interest on the interest you earned in previous years.
Use our compound interest calculator on the top of the page and see how much you can earn on even a small annual return.
Compound Interest Definition
The way compound interest works is that the interest is added to the principal balance for each term.
This means that interest is then earned on the additional interest added to the original sum over the course of the next compounding period.
You can see an example of how the compound interest effect works on a $1,000 investment below.
As you can see in the graph, compound interest grows exponentially over the years.
The primary benefit of compound interest is that you can earn interest on money you never invested, allowing your investments to grow quicker than they could without it.
Annual Compound Interest Formula
The annual compound interest formula is as follows:
A = P (1 + r/n) (nt)
In this case:
A = The future value of the loan or investment, including interest
P = The initial principal amount
r = The annual interest rate
n = The number of times the interest will compound on an annual basis
t = The number of years the money is borrowed or invested
This compound interest equation will yield the future value of a loan or investment, which is the principal plus compound interest.
To calculate only the compound interest, the formula is as follows:
Total compound interest = P (1 +r/n) (nt) – P
How Does the Compound Interest Formula Work?
Let’s take a look at an example to see the compound formula at work:
If you deposit $1,000 into a savings account with a 5% annual interest rate that’s compounded monthly, then the investment value after five years could be calculated as follows:
P = $1,000
r = 5/100 = 0.05
n = 12
t = 5
A = $1,000 (1 +0.05/12) ^ (12(5)) = $1,283.36
Of course, no one is expected to break out this equation every time you need to figure out compound interest.
Instead, you can use our free compound interest calculator, found at the top of this page for your convenience.