Understanding Compound Interest Is Key to Building Wealth or Avoiding Crushing Debt

The more interest rates are compounded, the faster the total amount of money accumulates. Pier/Getty Images

  • Compound interest occurs when previously earned interest is added to the principal amount invested or borrowed. It is commonly described as “interest earned on interest”.

  • Compound interest can work to your advantage as your investments grow over time, but work against you if you’re paying off debts, like credit cards.

  • If you are borrowing money, you want the interest to compound as infrequently as possible. if you’re investing, you want compound interest as often as possible.

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Warren Buffet once said that his wealth came from “a combination of living in America, certain lucky genes and compound interest”.

The billionaire investor meant that the interest from his investments helped him create his fortune. But Buffett also liked to warn people about the dangers of getting on the wrong side of the compound interest equation.

While compound interest is arguably the most important part of building wealth, it can also be one of the best ways to ruin your finances: having to To pay compound interest can cause debt to spiral out of control.

Most people think of interest only in terms of high or low rates. But understanding how interest is calculated, or compounded, is also important. Knowing how compound interest works can help you avoid costly mistakes and get the most out of your money, whether you’re depositing it, investing it, borrowing it, or spending it.

What is compound interest?

All interest is a percentage charged or earned by a lump sum of money. Compound interest is a kind of interest based on the addition of the initial principal – i.e. the initial amount invested or borrowed – with the accrued interest from previous periods.

For example, let’s say you have $100 in a savings account, and it earns interest at 10%, compounded annually. At the end of the first year, you would have $110 (100 principal + 10 interest). At the end of the second year, you would have $121 (110 in principal + 11 in interest). At the end of the third year, you would have $133.10 (121 in principal + 12.10 in interest). etc

In other words, with compound interest, you earn interest on interest.

The revelation comes when you realize that compound interest causes the principal to grow exponentially, which means that as the interest accumulates and the amount of money increases, the rate of growth accelerates.

How quickly your money grows depends on the interest rate and compounding frequency. Interest can be compounded daily, monthly, quarterly or annually, and the more frequently it is compounded, the faster it accrues.

In the long run, “the compounding magic” can really add up. Here’s how an initial investment of $5,000 would grow if compounded semi-annually over a 35-year period, at an annualized interest rate of 5%:

If you are the one income money on interest, daily or monthly compounding is preferable to yearly. On the other hand, if you are accused interest, monthly or annual capitalization will save you money compared to daily.

Compound interest vs simple interest

While compound interest is “interest on interest” – calculated on both the principal amount and accrued interest – simple interest is totally different. Simple interest is calculated alone on the initial capital balance or on the deposit.

Let’s go back to our $100 savings account, but this time it pays 10% simple interest. This means that the 10% interest rate only applies to your initial capital of $100, so you earn $10 each year. Period. At the end of the first year, you would have $110. But at the end of the second year, you would have $120. At the end of the third year, $130 — compared to $133.10 in the compound interest account.

Even though we’ve used small numbers here, you can see how the further you go, the more compound interest pays you – and the more it outstrips simple interest.

Simple interest tends to be used in most student loans, mortgages and installment loans – when you pay a store to buy a major appliance over a period of time, for example.

How to Calculate Compound Interest

Calculating compound interest sounds complicated, but it’s actually as easy as plugging a few numbers into the right formula.

Compound interest formula

The compound interest equation essentially adds 1 to the interest rate, raises that sum to the total number of compound periods, and multiplies the result by the principal amount. Shayanne Gal/Business Insider

Let’s say you decide to deposit your $10,000 annual bonus into a 5-year certificate of deposit (CD). You leave this money in the CD for the full five years, and it earns an annual interest rate of 4% compounded daily. The numbers you put into each variable are:

  • P = $10,000

  • r = 0.04

  • n = 365

  • t=5

The formula gives you $12,213.89 for A. This is the total amount of money you would have in your money market account after five years. That means you earned $2,213.89 in interest.

How Compound Interest Can Work Against You

As compound interest can be beneficial for saving, investing, and building wealth, it’s important to note that it can work against you if you’re paying off debt. In fact, compounding is part of what makes carrying an outstanding balance on a credit card so deadly.

In fact, the example above could be turned upside down by imagining that you have a balance of $10,000 on a credit card (we’ll assume that’s the same 4% compounded daily, even though the cards’ APRs credit are generally much higher). You plan to put nothing else on the card and pay it all off in five years. Even if you chipped away at your balance and paid an extremely low interest rate, you could still end up paying a lot of interest – over $1,000 in fact.

And if you were to pay 18% compounded daily — which is closer to the average credit card interest rate — you’d pay $5,236 in interest after five years.

How to get the most out of compound interest

The best way to take advantage of compound interest is to save and invest.

Opting for a savings account that pays interest — like high-yield savings accounts, money market accounts, and CDs — is one way to make compound interest work in your favor. When choosing an account, you’ll want to look for one with low fees and the highest annual percentage yield (APY), which is the interest you can earn on your deposit over a 12-month period.

It’s worth noting that interest rates on even the best savings accounts barely outpace inflation, so they’re best for short-term savings. If you want to build long-term wealth, whether it’s savings for retirement or a goal years from now, investing your money will really make it work for you.

Savings products offer interest rates that typically range from 0.01% to 3%, depending on the state of the economy, while the average historical rate of return on the stock market is 10%, before adjustment for inflation.

When opening an investment account like a 401(k), IRA, brokerage account, or mutual fund, you have the option of automatically reinvesting any dividends or interest your investments earn. This means that your returns will compound.

The financial statement

Compound interest can be your friend or your foe, with the power to make you rich or bankrupt, depending on your side.

Luckily, you don’t have to be a math whiz to figure out whether interest on an account will help or hurt you. If you’re borrowing money, you want the lowest interest rate possible, compounded as infrequently as possible. If you’re investing money, the reverse applies: you not only want a good interest rate, but one that accumulates early and often.

And when comparing loans, credit card APRs, savings account APYs, or other securities yields, check how often interest is compounded and make sure you’re comparing like-for-like. Two interest rates can be nominally the same, but if they accumulate at different rates, it can make a big difference.

Whether earning it or paying for it, the nature of compound interest means it’s exponentially – pun intended – better for your wallet.

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