What is Compound Interest?

Compound interest is a combination of the interest you get from money you save and all the subsequent interest you earn on it. The money you initially save is referred to as ‘principal’, and that principal as well as the interest that principal earns continues to generate income for the duration the money is saved. The ‘magic’ of compound interest is that it can help your money exponentially grow.

You can accumulate compound interest on money in a savings account, stock market investments, and on debt. That said, compound interest is a powerful tool that can be used as a low hanging fruit when it comes to building wealth. Likewise, compound interest can make debt snowball when interest rates for the debt are high.

The Basics Of Compound Interest

The key to compound interest working in your favor is time. The longer you leave your money to grow, the more time your interest has to compound. Another way to make your money grow fast is to keep adding more cash to your initial principal, so there are more dollars generating interest for you.

Here are some basics to help you understand how to calculate compound interest and see your money’s potential for growth.

Compound Interest Formula

There are several ways to calculate compound interest and one is to use the formula
A=P*(1+r/n)^n*t.

Here is a breakdown of what each letter in the equation stands for.

P is the initial principal amount
R is the annual interest rate
N is the frequency of times interest compounds every year
T is number of years or time in years

So, for example, a $1,000 investment today with a 10% interest rate that compounds annually for five years will give you $1,611.

As an equation, that looks like:

$1,611= ($1000*(1+.1/1)^(1*5)

An alternative to doing manual compound interest calculations is using a compound interest calculator.

Rule of 72

Some people want to know how long it will take for compound interest to double their initial investment or principle, and this is where the rule of 72 comes in. To figure out how long it will take compound interest to double your investment, divide 72 by your rate of return.

If we go with the example above and use a 10% rate of return, then that initial $5,000 deposit would grow to $10,000 in about 7.2 years.

Compound Interest Periods

Compound interest can happen daily, monthly, quarterly, or yearly and the interest is typically added to your principal balance. Every financial product has a different schedule when it comes to compounding. For instance, a savings account may compound interest daily, while a certificate of deposit may compound interest every six months.

Examples of Compound Interest

Let’s say you invest $5,000, it earns 10% interest every year, and you let it sit for two years. Your money would grow to $5,500 by the end of the first year. That’s a sum of your initial $5,000 principal plus 10% interest, which is $500.

$5,000 (principal) + $500 (10% annual interest) = $5,500

The second year, you would have about $6,050 and this is where the compounding magic begins to happen as you start making interest on interest.

$5,500 (principal + interest from year 1) + $550 (10% interest of $5,500) = $6,050

In two years, you would have made $1,050 just by keeping your money saved. In the case of stock market investments, if you choose to invest your money in dividend stocks, and reinvest the dividend payments, your money can compound at an even faster rate.

Investments That Offer Compound Interest

There are multiple ways to earn compound interest and some include:

Compound interest stands as a powerful financial force, capable of turning small, consistent investments into substantial wealth over time. The magic lies in the compounding effect, where interest not only accumulates on the initial principal but also on the previously earned interest. This compounding snowball effect emphasizes the importance of starting early, being patient, and consistently contributing to your investments. By understanding and harnessing the potential of compound interest, individuals can pave the way for financial growth, long-term stability, and the fulfillment of their future goals. In the realm of personal finance, compound interest serves as a steadfast ally, rewarding those who nurture and embrace the power of time in building a prosperous financial future.