Compound interest is the holy grail of investing and, depending on the circumstances, can be much more lucrative than traditional simple interest. Here’s what you need to know.
What is compound interest and how does it work?
Compound interest allows you to earn interest on your original savings and the interest income accumulated on those savings. This exponential growth allows you to earn more money faster than you would with just simple interest.
Interest is compounded at a set frequency that varies depending on the product. The frequency could be daily, weekly, quarterly or annually. The more often your money is compounded, the faster it will grow.
Unlike fluctuating stock market returns, compound interest projects returns, making it easier to know how long you need to save. This is especially handy for specific savings goals, like a wedding, a down payment for a home, or retirement.
However, as lucrative as compound interest can be for things like savings accounts and interest-bearing investments, it can also cost you more when you borrow money. You need to be cautious of debt with compounding interest because the amount you owe will snowball over time.
» MORE: How to save money
How to calculate compound interest
The easiest way to calculate compound interest is to use a compound interest calculator. You can find these for free online with a quick Google search. But, if you don’t have that handy you can also go the old fashioned route and use the following formula:
To complete the equation, you will want to
- Solve the parenthesis (1 + interest rate)
- Tackle the exponent, which is the value in the parenthesis to the power of the number of compounding periods.
- Multiply by the original principal amount to get the total principal plus earned interest.
If you want to know how much of that amount is just interest, subtract the original principal.
Here’s an example:
Let’s say you want to know how much compound interest $10,000 can earn in a year. If you invest that $10,000 into a high-interest savings account at an annual interest rate of 2% that is compounded monthly, you will get the following:
i= 0.167% ( 2% annual interest, divided by 12 months)
=$10,000 x 1.0202
=$10,202 total principal and interest
Of that amount, $202 is compound interest earned. That’s quite a lot of money earned for, essentially, not doing much at all.
Types of products that use compound interest
As mentioned above, there are all kinds of products that use compound interest. Some work in your favour and others don’t.
These are some of the most common financial products that have compound interest.
- Savings accounts
- Guaranteed investment certificates (GICs)
- Credit cards
Simple interest vs. compound interest
The main difference between simple interest vs. compound interest is what earns the interest.
With simple interest, earnings are calculated on the principal only. So if you have a $10,000 deposit earning simple interest, you will earn interest only on that $10,000, no matter how long you have it invested for or how much interest accumulates.
In our compound interest example above, on the other hand, you’d earn interest on the entire $10,202 in the next month, not just the original $10,000 deposit.
Compound interest is great for saving. So try to find savings accounts or investments that pay compound interest. But, compound interest can quickly work against you when it comes to loans and debts, so it’s better to have simple interest in these cases.
» MORE: How does an annual percentage rate (APR) compare to an annual percentage yield (APY)
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