What is compound interest? How it works to turn time into money

Compound interest can help turbocharge your savings and investments, or it can quickly lead to an unruly balance, keeping you stuck in a cycle of debt. Its magic can help you earn more or owe more.

As you get closer to retirement, you can use the power of compound interest in your favor. The longer your time horizon is, the longer you have for compound interest to quickly grow your assets. Unlike simple interest, compound interest has a cumulative effect over time. In this guide, learn what compound interest is and how compounding works.

Compound interest defined

“In its simplest form, compound interest is earning or accumulating interest from previous periods on top of each other over time,” says Daniel Milan, investment advisor representative and managing partner at Cornerstone Financial Services. “Where simple interest is calculated solely on the principal value, compound interest is calculated on the principal, plus interest from previous periods.”

Compound interest is the interest earned on that higher balance. Often described as earning interest on your interest, compounding is done on a schedule — such as daily, monthly or annually. Typically the more frequent the compounding, the more compound interest you can earn.

How compound interest works

Compound interest works by applying interest to both your initial deposit or principal balance and any interest that deposit or balance has accrued along the way based on the compounding frequency:

• For deposit accounts — like high-yield savings accounts or CDs — it means that each time interest is calculated, it’s earned on your combined original deposit and accumulated interest you earned on it previously, which then becomes your new bigger balance that accrues interest the next round of compounding.

• For loans — like mortgages and home loans — it means that each time interest is calculated, you’re paying interest on both the original amount you borrowed and accumulated interest added to it previously as you pay down what you owe. This compounding factors into your mortgage’s amortization schedule: In your first years of a mortgage, more of your monthly payment goes toward interest, whereas later in the loan, more of your payment goes toward your principal.

How to calculate compound interest

On your own, it can be challenging to figure out how to calculate compound interest. The basic compound interest formula for deposit accounts is:

A = P(1 + R/N)^NT

Here’s what the letters represent:

• A is the amount of money in your account

• P is your principal balance you invested

• R is the annual interest rate expressed as a decimal

• N is the number of compounding periods in a year

• T is the time periods to calculate in years

Let’s say you’re depositing $10,000 into a high-yield account with a 5% APY compounded monthly. You must convert the APY into a decimal by dividing the amount by 100. In this case, 5/100 = 0.05.

Since this example has monthly compounding, the number of compounding periods would be 12. And the time to calculate the amount for one year is 1.

Calculating compound interest with an online calculator, physical calculator or by hand results in $10,511.62 — or the final balance you could expect to see in your account after one year, thanks to compounding.

The power of compounding: How compound interest benefits your savings

If you’ve ever wondered how someone attained a sizable nest egg or amassed millions, compound interest surely played a role. Compound interest is the secret ingredient when it comes to building wealth.

So the good news is that you don’t need to save what can seem like an astronomical amount all on your own. Instead, you can use the power of time to save or invest consistently and let compound interest do the heavy lifting. The most powerful growth engine for compound interest is time. Having a long time horizon can amplify your assets and catapult the balance to greater heights.

If compound interest had a theme song, it would be “Time Is on My Side” by the Rolling Stones. If you’re getting a late start and feel behind, there’s still time to utilize the magic of compound interest. It may mean pushing back retirement a few years or making some lifestyle changes, but it’s possible to get your investment to grow.

To see the magic in action, let’s look at numbers for an early investor, a late starter and a later starter who’s committed to regular contributions to their savings.

The early investor

Let’s say you have an initial investment of $10,000 at 25 years old. You don’t contribute anything else, but you let that deposit compound for 40 years until the age of 65 with a projected return of 7%.

With an annual compounding frequency, that $10,000 investment would grow to $149,744.58.

The late starter

If you invested that same $10,000 at age 55, you’d have a much smaller amount to draw from by the age of 65.

Using that initial investment and no other contributions, with a projected return of 7% and annual compounding, you’d end up with $19,671.51 in 10 years.

The late starter — plus monthly contributions

Let’s imagine that you invest that same initial $10,000 at age 55, but you commit to contributing $500 each month to your investment for the next 12 years, until age 67.

Using an estimated 7% and annual compounding, you’d end up with $129,852.62 — or some $110,000 more than not contributing extra money each month, nearly $58,000 of it due to compounding.

While this amount might still fall short of your goals, you’d be in a position to take advantage of Social Security as well.

How compounding affects what you owe

Compounding can be a wonderful gift and help with your retirement planning. But it can also be an albatross on your neck if you have any loans or credit cards with compound interest. The accelerated growth and snowballing interest can make it challenging to pay off debt, like two steps ahead, one step back.

Say you have $10,000 in credit card debt at 20% APR. It would take you 60 months (or five years) of $266.67 monthly payments to pay off the balance, and you’d end up paying $5,823.55 in interest over that time — about 37% of your total payments.

If you added $500 to the minimum payment and put $766.67 to your credit card balance each month, it’d take just 15 months to pay off the balance and you’d pay $1,369.33 — or about 12% of your total payments — in interest.

Just as compounding can accelerate your savings and investments, it can also make your debt balloon to unmanageable levels if you’re not careful.

Dig deeper: I’m a financial expert: Here are my 4 top tips for paying off your credit card debt

How often do accounts and balances compound?

When looking at how compound interest works, a major component of that is the compounding frequency. Different financial products apply different compounding frequencies, as you can see in the chart below.

However, these frequencies are only a benchmark and can vary by bank or creditor, so it’s always a good idea to check yourself. Something to note is that while savings accounts and credit cards might compound daily, the payout or charge is applied monthly.

How to take advantage of compound interest

Knowing what compound interest is and how compounding works are one thing. Taking advantage of it is another and requires action on your part.

Here’s how to take advantage of compound interest:

1. Start right now. No matter where things stand with your savings and investments, start where you are and continue to set aside money. Time is what makes compound interest grow into something substantial.

2. Know your rate of return. For many savings products, rates are expressed as an annual percentage yield, or APY. Your APY already has the compounding frequency baked into it and shows how much interest you’ll earn in a year’s time. Your interest rate doesn’t include compounding and determines the amount of interest you’ll accrue on your principal balance.

3. Review your compound frequency. Compounding frequency can change based on the type of account and financial institution. You’ll get the most benefit from frequent compounding. That can come in handy if you’re shopping around for different types of accounts.

4. Stick to it. Imagine your retirement funds are like a lush garden that needs watering. In this case, you can keep your retirement funds healthy and growing by consistently adding to your account. Even if you put away less in some months than others, the point is to continue building the habit and taking advantage of how compounding works.

What to know about compound interest and taxes

Compounding works to grow your savings and investments, but be aware that much of the interest you’ll receive is taxable income in the eyes of the Internal Revenue Service (IRS).

“Interest earned on savings accounts, bonds and CDs is taxed as ordinary income, which can chip away at your gains,” says Tyler Meyer, a certified financial planner and founder of the blog Retire to Abundance. “However, tax-advantaged accounts like IRAs and 401(k)s allow you to defer taxes, so your money can grow without the IRS taking a cut until you withdraw it. With a Roth IRA, your investments grow tax-free, provided you follow the rules, which can make compound interest even more beneficial.”

Dig deeper: How all 50 states tax retirement income: A comprehensive list

FAQ: Savings, investing and planning for retirement

Compound interest can multiply your money to grow your savings faster. Learn more about how to save, invest and plan for a comfortable retirement.

I’m retired. What low-risk investments should I look into?

It’s not realistic to think you can invest your money with zero risk. However, there are several accounts and assets that can help you grow your money while minimizing the impact of the market’s ups and downs on your retirement funds, including high-yield savings accounts and CDs, mutual funds and Treasury bonds. Start with our roundup of the best low-risk investments for steady gains in your golden years, including tips for new investors.

I’ve saved up $10,000. Where’s the best place to put it?

Saving up $10,000 is an impressive milestone that opens up several financial opportunities that can better position you for a more stable financial future. You can put it to work through passive income streams, contribute to growing a retirement fund or pay down high-interest debt. See our guide to the five smartest moves to make with your $10,000.

Can I have more than one savings account?

Yes, you can have more than one savings account. While some banks may limit you to one account, you can always open new accounts with other banks. This can help you spread out your money, benefit from different perks each bank offers and even access more FDIC coverage to protect what you earn. Stay on top of banking benefits, products and news to find what works best for you.

Should you keep more than $250,000 in one bank?

It’s not a good idea to keep more than $250,000 in a single bank account if there’s just one person listed as the account owner. This is because you’ll exceed FDIC limits — meaning any amount over $250,000 could be at risk if the bank were to fail. If you have a joint account, you can keep up to $500,000 in a single bank account, because the $250,000 limit applies to each of you. Of course, if you have a cash management account or DIF coverage, your limits might be higher. Learn expert rules of thumb about how much you should keep in a savings account, in a certificate of deposit and in a checking account.

Sources

About our writer

Melanie Lockert is an L.A.-born and Brooklyn-based freelance writer with a decade of experience in personal finance. Melanie started the Dear Debt blog in 2013 and chronicled her journey out of $81,000 in student loan debt. She published a book of the same name in 2016. Her personal finance expertise has been featured on Fortune Recommends, CNN Underscored, Yahoo Finance and Business Insider, among other publications. She is also the host of the Mental Health and Wealth Show and cofounder of the Lola Retreat, a finance event for women.

Article edited by Kelly Suzan Waggoner