Albert Einstein is rumored to have said, “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn't…pays it.”
For savers and investors, the power of compound interest can significantly increase wealth over time. But for borrowers, compound interest can make loans much more expensive.
Here is an overview of compound interest and how it affects savings, loans, and investments.
What is Compound Interest?
When you open a financial account or take out a loan, the initial amount of money is known as the principal. Whenever interest is accrued based only on the principal amount of a loan or deposit, it is known as “simple interest.”
By contrast, “compound interest” is the accrual of interest on the principal of a loan or deposit, with a snowball effect so that any interest accrued going forward is earned on the principal plus any previously earned interest. In other words, your interest is earning interest!
Here is an example that compares compound interest and simple interest. Let’s say you put $10,000 into a financial account that earns 5% interest per year. Under the rules of simple interest, the account would earn $500 per year ($10,000 * 0.05), so it would be worth $10,500 after one year and $11,000 after two years. However, under the rules of compound interest, the account would be worth $10,500 after one year ($10,500 * 0.05) and $11,025 after two years ($10,500 * 0.05), assuming it compounds on an annual basis. All else being equal, the gap between an account that earns simple interest and an account that earns compound interest would grow even more over time.
The longer you save and invest, the more time compound interest has to work its magic. Some of the other factors that influence the amount of compound interest you will earn include the amount of your principal, the interest rate, and the frequency of compounding. For example, the compounding frequency might be daily, monthly, quarterly, or yearly. The more frequently that interest is compounded, the greater the amount of compound interest.
The same concepts hold true for borrowers, but ultimately result in paying more money rather than earning more money.
If you have a student loan or a mortgage with compounding interest, you will end up owing more money because your interest will be earning interest. The longer it takes to pay off a loan, the more interest you’ll pay in the end. This is one of the reasons why it is so important to read any loan terms carefully and to pay off debt as soon as possible.
To get an idea of how compound interest might work for your financial situation, use a compound interest calculator Off Site Link.
What Types of Accounts Offer Compound Interest?
There are several types of financial accounts that earn compound interest. Some of the accounts include high-yield savings accounts, certificates of deposit (CDs), and money market accounts. All of these accounts pay interest at regular intervals, often monthly, and tend to be low-risk because they guarantee at least some return.
The interest rates for high-yield savings accounts and money market accounts vary based on market conditions, while CDs offer fixed-interest rates for a specified period.
What Types of Investments Offer Compound Interest?
If you have a brokerage account, you may choose to buy mutual funds or stocks that pay dividends, which work in a way similar to compound interest.
Whenever your stock or mutual fund pays dividends, you can reinvest those dividends in order to further grow your wealth. In fact, many stocks and mutual funds offer the option to automatically reinvest dividends into more of the same stock or fund.
Some types of bonds also draw upon the concept of compound interest. More specifically, zero-coupon bonds are purchased at a discount (such as a $1,000 bond for only $950) because bond issuers calculate the bond’s value at maturity based on the amount of compound interest that will be accrued over time.
Compound interest can have an outsized effect on your finances. To learn more about how interest works for investments and loans, explore our Personal Finance Resource Center.