What is compound interest?

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Editor’s note: The APYs listed in this article are current at the time of publication. They can fluctuate (up or down) when the Fed rate changes. Select will be updated as changes are made public.

Compound interest is a term you’ve probably heard of, but understanding how it works can save you money in the long run.

A study that looked at information from S&P’s Global Financial Literacy Survey found that “consumers who don’t understand the concept of interest compounding spend more on transaction costs, accumulate more debt, and incur higher interest rates on loans”.

Whether you regularly use a credit card or save money in a high-yield savings account, it’s important to note that interest is compounded, which means what you owe or earn can be accumulate quickly.

Below, CNBC Select breaks down the difference between simple interest and compound interest, how the latter works, and how you can benefit from understanding compound interest.

Simple Interest vs Compound Interest

Simple interest is calculated based on the original amount you borrowed or what you have in the bank. This is called your “main”. Simple interest applies a fixed rate, which means that the interest remains the same for the duration of the loan or account.

Compound interest, however, is calculated on your principal amount, plus your accrued interest. This rate is variable and may change at any time. It basically pays interest on top of interest.

Compound interest can work against you or in your favour, depending on whether you are borrowing or saving money. Below, we take a look at how much you could end up paying and earning with compound interest.

How compound interest works on your credit card

Let’s take a look at a hypothetical example of how compound interest can work against you.

Using 5, 10 and 15 year maturities, we can see the effect of an interest rate of 16.61% (the average credit card APR according to the most recent data from the Federal Reserve ) on a credit card balance of $6,194 (the average credit card debt of Americans). We have assumed that you are only making the minimum payment.

Total credit card balance Interest accrued
The principal amount $6,194 $0
After 5 years $9,158 $2,964
After 10 years $15,698 $6,540
After 15 years $26,355 $10,657

As you can see from the table above, compound interest alone proves to be quite expensive over time, so much so that it exceeds your original balance after 10 years.

How Compound Interest Works in a Savings Account

If you deposit even a small amount of money into a savings account, compound interest can do the work for you and make your money grow exponentially faster than it would with interest. simple.

People often refer to compound interest as “money making money”. To see how compound interest can make you money, let’s take the hypothetical example of depositing that same $6,194 into a high-yield savings account. We will use 1.21% as the interest rate, which is the current APY for the Vio Bank High Yield Online Savings Account and the Varo Savings Account.

For this example, we assume that you make no monthly contributions or withdrawals and that interest is compounded daily.

Use simple interest Use of compound interest
The principal amount $6,194 $6,194
Savings after 5 years with 1.21% interest $6,568.74 $6,580.30
Interest accrued $374.74 $386.30
Savings after 10 years with 1.21% interest $6,943.47 $6,990.69
Additional accrued interest $374.73 $410.39
Savings after 15 years at 1.21% interest $7,318.21 $7,426.67
Additional accrued interest $374.74 $435.98
Total interest accrued after 15 years $1,124.21 $1,232.67

Compound interest can make your savings grow faster. While you earn about $374.74 every five years with simple interest, you will earn interest on the new balance (principal + interest) when you have an account with compound interest.

It is important to note the frequency of compounding as it can vary. Your interest could be compounded daily, monthly, quarterly, semi-annually or annually. The more frequent the compounding periods, the higher the interest and the faster your money grows.

How to take advantage of compound interest

At the end of the line

Before you open a new credit card or savings account, be aware of the impact compound interest can have on your debt or savings. Using the examples above, on the one hand, you pay $10,657 in interest only after 15 years, but if you put that same amount in a high yield savings account, you could earn $1,232.67 in interest within the same period.

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Editorial note: Any opinions, analyses, criticisms or recommendations expressed in this article are those of Select’s editorial staff only and have not been reviewed, endorsed or otherwise endorsed by any third party.

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