Compound Interest

Compound Interest
Compound interest is interest that adds to a loan’s principal as it accumulates.

What is Compound Interest?

Compound interest is interest that is added to a loan’s principal as it accumulates. This causes the rate at which the interest grows to increase over time.

What is the difference between simple interest and Compound Interest?

An interest rate is calculated as a percentage of the amount taken as a loan, or principal. With simple interest, the amount of interest owed is kept separate from the principal, so every month or year, the amount of interest added will be consistent.

Compound interest is added to the principal as it accumulates. That means that even though the interest percentage remains the same, the amount of interest added will be higher after each compounding.1

As an example, imagine that you took out a $100 loan at a 10% monthly interest rate, and you plan to pay it back in three months. With a simple interest rate, you’ll pay $130, because of the $100 principal, plus $10 in interest for each of the three months. Simple!

Now imagine that $100 loan has a compound interest rate of 10%. Assuming the interest compounds every month and you’re still going to be paying it back in three months, you’ll end up paying $133.10. That’s because after the first month, $10 will be added to the principal, bringing it up to $110. The second month, 10% of $110, or $11, will be added to the principal, totaling $121. Finally, for the third month, $12.10 will be added to the principal, for a total payment of $133.10.

Of course it’s never going to be that simple in real life, so you’ll likely need a calculator.

How often is Compound Interest compounded?

Every time interest is added to the principal, that’s called compounding. Different compound interest loans will compound the interest at different rates, whether it’s daily, monthly, annually, or some other timeframe. The more often the interest compounds, the faster the principal will grow, and the more interest will be added to the principal. And the more interest that gets added to the principal, the more interest that will be added to the principal going forwards.

What kind of loans use Compound Interest?

Many loans use compound interest, so it’s up to you to be certain what kind of interest any given loan might have before you borrow.  Credit card loans and student loans are two kinds of loans that are likely to use compound interest. Many student loans even compound interest daily!2 It’s important that your payments are amortized, which means that each payment pays off part of the interest as well as the principal. Without a proper payment schedule, you could end up paying off the interest on a compound loan forever as the principal keeps growing.

Is Compound Interest always worse?

Not if you’re the lender! One way that you can earn compound interest is with a savings account. Most savings accounts will allow you to earn compound interest, though the interest rates tend to be quite low, so you’ll need to either deposit a large amount of money or wait a very long time to get a big return on your deposit. Since saving money is a smart thing to do anyway, though, you can consider the interest a nice bonus. Some savings bonds will also earn you compound interest.3

If you’re the borrower, however, compound interest is almost always going to cost you more than a similar loan using simple interest. Still, when comparing loans be sure to use their annual percentage rates, or APR, which will tell you the total cost of any given loan, including interest and fees. That way you’ll know for sure which loan is most affordable for you.

References:

  1. “The Different Types of Interest.” Money Habits accessed on February 28, 2017 at
    http://www.moneyhabits.com/types_of_interest.htm.
  2. maryjo. “Compounding vs Amortizing Interest-the Untold Story.” Fiscal Bridge accessed on February 28, 2017 at http://fiscalbridge.com/compounding-vs-amortizing-interest-the-untold-story/
  3. “What Kind of Investment Accounts Earn Compound Interest?” The Motley Fool accessed on February 28, 2017 at https://www.fool.com/knowledge-center/what-kind-of-investment-accounts-earn-compound-int.aspx.