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Compound interest definition
Compound interest is the money your bank pays you on your balance — known as interest — plus the money your interest earns over time. It’s a way to make your cash work for you. How quickly your money grows is determined by your rate, bank balance and the number of times your bank pays interest, or “compounds.”
How compound interest works
Say you put $5,000 in a savings account with an annual percentage yield of 2%, and your account compounds interest monthly. If you don’t make additional deposits, after one year, your balance would grow to about $5,101.
In future months, that extra $101 will continue to earn interest, along with the original deposit of $5,000. Without touching your account, you’d have more than $5,300 at the end of three years.
If you make monthly contributions of $100 during the same three-year period, those additional deposits will earn interest, too. With monthly compounding, you’d accumulate more than $9,000 by the end of the third year.
» Want to see how fast your own savings could grow? Use the NerdWallet compound interest calculator.
You can take advantage of compound interest as long as you have an account that offers a return, but you’ll want to find the best interest rates. The national average rate for savings accounts is currently 0.33%, but some institutions offer much more. Many online banks, for example, have rates more than 10 times the national average.
» Looking for more options? Read NerdWallet’s list of best high-interest savings accounts.
Here’s a chart that shows how a $5,000 balance could grow over a period of three years. This assumes you make $100 monthly contributions and the interest rate is 0.55% APY. You can find better rates with the best savings accounts, but that yield is better than average.
Many banks reserve the right to raise or lower the interest rate on a savings account at any time. If you want to earn compound interest at a consistent rate for a specific time frame, consider opening a certificate of deposit. You can read NerdWallet’s primer on CDs to learn more.
The difference between simple interest and compound interest
Simple interest occurs when your bank pays interest on your original balance. It’s an easy equation: Start with the balance and then multiply it by the interest rate for your selected time period. That amount is what the bank deposits to your account at the end of the term.
You could choose to withdraw the interest earned. But if you leave that extra money in your account, it will earn more interest over time, compounding the original interest payment. That is what is meant by compound interest.
In the example above, a simple calculation of 0.55% multiplied by $5,000 is $27.50. But with monthly compounding, the earnings after one year are a bit larger, at $27.57. It may not seem like much, but it adds up. The higher the rate and your balance, and the more the balance compounds, the more you’ll earn.
Many online savings accounts are attractive because they compound daily instead of monthly. Marcus by Goldman Sachs (read review here) and American Express (read review here) are examples of such accounts.
The compound interest formula
Here is how to compute monthly compound interest for 12 months: Use the formula A=P(1+r/n)^nt, where:
A = ending amount
P = original balance
r = interest rate (as a decimal)
n = number of times interest is compounded in a specific time frame
t = time frame
An easier way to calculate how much you can earn is to use NerdWallet's compound interest calculator. You can adjust the compound frequency to calculate your balance with daily, monthly or annual compounding. You can also factor in additional deposits to your account.
Compound interest can help supercharge your savings. It is effectively interest on interest, and it can give your bank balance a nice boost over time.