Compound interest is one of the most important components of wealth-building. This powerful force can help your accounts grow much quicker than just setting aside a few hundred bucks a year. But if you’re on the wrong side of the equation, you’re more likely to see your money flushed away.
In a nutshell, compound interest is the money earned and reinvested on a loan or deposit. It’s calculated at regular, defined intervals, with each new period accounting for any accumulated interest from the previous period.
In other words, it’s “interest on interest” that makes your balance grow faster than simple interest can. (Simple interest is calculated solely on the initial deposit or loan amount.)
As a result, your money (or debt) grows exponentially, rather than in a linear line, which can cause the balance to snowball more quickly as time passes.
Calculating compound interest is fairly simple once you know how to break down the equation. Though it looks intimidating, it’s just a matter of plugging the correct variables into the following equation:
A =P(1+ (i/n))^nt
In this formula:
Let’s break this down further with a couple of quick examples. Say that you deposit $10,000 into a 10-year CD that earns 5% annual interest compounded daily. In this example:
So, your formula would look like this:
A = $10,000(1+ (0.05/365))(365)(10) = $16,486.65
In other words, over ten years, your account balance would grow to $16,486.65, which comes out to $6,486.65 in interest.
You can also use this equation to see how the frequency of compounding may affect your earnings. Using the same example above, let’s now say that your CD of choice only compounds annually. Your equation would look like this:
A = $10,000(1+(0.05/1))(1)(10)
In this example, your account would grow to $16,288.95, or about $200 less in earned interest over 10 years.
If you’d prefer not to calculate your returns by hand, you can use a simple calculator like the one at Investor.gov. It even generates a handy chart to visualize your earnings potential!
The best way to take advantage of compounding is by saving and investing. The earlier you save and invest, the longer compound interest has to grow your wealth. It’s that simple.
Savings accounts provide a valuable haven for your short-term savings. High-yield savings accounts, money market accounts, and CDs can make interest work in your favor. The key is to find accounts with minimal fees, higher APYs, and more frequent compounding schedules.
But interest rates on the best accounts pale in comparison to the historical rate of return for the stock market, which averages 9-10% (before inflation).
Thus, if you really want to build wealth and capitalize on your earnings potential, investing – whether in a retirement or brokerage account – is your best friend. Look for risk-adjusted accounts with minimal fees and automatic dividend reinvestments to boost your returns.
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