What is Compound Interest and How It Impacts You

Why compound interest deserves your attention

Compound interest can make you rich or bury you in debt. Albert Einstein called it the “eighth wonder of the world,” an analogy that resonates with anyone who’s benefited from wise investing and strategic asset allocations. This article explains how that works and what you need to know to take advantage of it. Here are some key takeaways:

1. Compound Interest Grows Your Money Faster: Unlike simple interest, compound interest earns interest on both the original amount and the accumulated interest, accelerating growth over time.
2. The Earlier You Start, the Greater the Impact: Time is the most powerful factor in compounding. Starting early, even with small amounts, can lead to significantly greater returns than starting later with larger contributions.
3. Simple vs. Compound Interest: Simple interest is calculated only on the principal. Compound interest includes past interest. Understanding this difference is critical for saving and borrowing decisions.
4. Compound Interest Can Build Wealth or Deepen Debt: It's a double-edged sword that’s great for savings and investments, but costly for debts like credit cards if only minimum payments are made.
5. You Can Maximize Compound Interest with Small Steps: Automating savings, using tax-advantaged accounts, reinvesting earnings, and avoiding high-interest debt are all effective ways to harness compounding for your benefit.

What is compound interest? A simple explanation

Compound interest is interest earned on interest. That’s the simplest explanation we can provide. If you invest $1,000 in an account that earns 5% interest compounded annually, you’ll receive $50 at the end of the first year and 5% of $1,050 at the end of the second year, provided you leave your interest payment in the account. This accelerates the growth of your funds.

Imagine that same scenario, but this time the interest compounds monthly. In a growth account, that could make your money grow exponentially faster, but this principle also applies to debt accounts. Credit card companies, for example, charge compound interest on unpaid balances. That’s why making more than the minimum payments each month is recommended.

How does compound interest work?

This concept can be complicated if you don’t know the math behind it. Thankfully, you don’t need to be a mathematician to understand this. The compound interest formula is:

A = P(1 + r/n)^nt

• A = Final amount
• P = Principal (your starting amount)
• r = Interest rate (as a decimal)
• n = Compounding frequency (how often interest is calculated)
• t = Time in years

The interest rate and compounding frequency are the numbers that determine growth. Money that compounds monthly grows faster than annually compounded money. Daily compounding makes it grow even faster. Let’s look at that same $1,000 over ten years with 5% interest:

• Compounded annually: $1,628.89
• Compounded monthly: $1,643.62
• Compounded daily: $1,648.61

The difference isn't huge, but it's free money for doing absolutely nothing. Always look for accounts that compound more frequently when you're saving.

Simple interest vs. compound interest

Go back to our first example. Putting that same $1,000 into a savings account with a 5% simple interest rate means it will only gain $50 per year. This is called “linear growth.” Accounts with a compound interest rate experience “exponential growth.” Here’s a detailed breakdown:

• Simple interest is calculated only on your original principal amount. If you have $1,000 earning 5% simple interest annually, you'll earn exactly $50 every year, no matter how long you leave the money there.
• Compound interest gets calculated on your principal plus all previously earned interest. Using the same $1,000 at 5%, you'll earn $50 the first year, $52.50 the second year, $55.13 the third year, and so on.

Real-world examples:

• Auto loans and personal loans typically use simple interest
• Savings accounts and retirement accounts use compound interest
• Credit cards compound interest against you (more on this below)

The benefits of compound interest

Einstein held compound interest in such high regard because he recognized it as the key to wealth building, especially for those who start early. The benefits include:

• Long-term wealth building: Saving even a small amount each week can generate a significant sum over time with compound interest. For instance, depositing $25 a week starting at age 25 could grow into $400,000 by age 65.
• Passive income generation: Growing your accounts with compound interest is classified as passive income. Your money works while you sleep.
• Rewards for consistency: It takes patience and consistency to reap the rewards of compound interest. Stay with it, no matter how much you’re putting in.
• Regular contributions: The table below shows how different weekly savings amounts can grow by age 65, assuming a 6% annual return:

The key applications for compound interest include:

• 401(k) and IRA accounts: Your retirement contributions compound tax-deferred
• High-yield savings accounts: Emergency funds that grow
• Dividend reinvestment plans: Let your stock dividends buy more shares automatically

Is compound interest good or bad?

The good of compound interest is clear, but the bad can negatively impact your finances. Here’s a breakdown of what that looks like:

The good (when you're earning interest):

• Builds wealth passively over time
• Rewards early savers with exponential growth
• Encourages long-term financial planning
• Creates momentum that makes saving easier as balances grow

The bad (when you're paying interest):

• Increases debt exponentially if you only make minimum payments
• Makes high-interest debt nearly impossible to pay off
• Compounds against you on credit cards, payday loans, and other high-cost borrowing

We’ve already provided several examples of the good. Credit cards are the best example of bad compounding. If you carry a $1,000 balance on a credit card with an 18% compounded APR, it could cost over $600 in interest over the roughly eight years it would take to pay it off with minimum payments (usually 3% of the balance). If you invest that $1,000 in a compound growth account and get an 8% annual return, you’d turn it into $2,159 over ten years.

How to maximize compound interest

Finding compound interest opportunities requires research and strategic thinking. Here are a few tips that can help you get the most out of it:

• Start Early, Even with Small Amounts: Older adults often tell their children they wish they had started saving early. That’s especially true with retirement accounts. Starting at age 25 or 35 will make your retirement years more comfortable.
• Contribute Regularly: Setting up automatic deposits from your paycheck or bank account will help you stay consistent in your savings plan. Even $10 per week ($520 per year) can compound into meaningful money over decades.
• Use Tax-Advantaged Accounts: Certain retirement accounts can be used for compound growth that won’t be taxed until you take disbursements. Common examples of this are 401(k) plans, 403(b)s, and Roth IRAs.
• Reinvest All Earnings: Investment accounts earn interest and dividends over time. Reinvesting these rather than taking them will help your money grow faster. Most accounts have automatic reinvestment options.
• Avoid High-Interest Debt: Prioritize high-interest investing over high-interest debt. Credit card debt at 20% APR will accumulate much faster than most investment accounts. Focus on paying the debt before investing in new accounts.
• Choose Higher-Yield Options: Shop around for savings accounts, CDs, and investment options that offer better returns. Even an extra 1% annually makes a significant difference over time.

Conclusion

Compound interest is the foundation of long-term wealth building. If you start early, you can use this principle to build significant retirement savings over time. A 25-year-old saving $25 per week will likely have more money at retirement than a 35-year-old saving $50 per week, assuming identical returns. Do the math to see how that works.

Unfortunately, compound interest can also work against you if you have debt accounts, particularly credit cards. It’s important to prioritize paying those off before you start saving because the compound interest rate is usually in double digits. Once that’s done, look for compounded tax-advantaged accounts you can use for wealth building.