What Is Compound Interest?

Compound interest is one of the most important components of wealth-building. This powerful force can help your accounts grow much faster than just stashing money under your mattress each year. But if you’re on the wrong side of the equation, compound interest can suck your money away.

What is compound interest?

In a nutshell, compound interest is the money earned and added to the principal balance of a loan or deposit. In other words, it’s the interest that you earn on top of interest. As your principal grows, your balance increases exponentially, rather than in a linear line. Over time, compound interest snowballs your earnings – or debts.

How does compound interest work?

Compound interest works by added interest to your principal at regular, defined intervals. When each new period begins, your interest is calculated based on your new principal – the sum of your initial principal plus accumulated interest.

How often does interest compound?

Different accounts and investment assets compound at different frequencies.

Frequency – the number of compounding periods over time – makes an enormous difference in your long-term earnings.

In simple terms, the more often your interest compounds, the faster your earnings grow. In the reverse, the more frequently your debts compound, the faster your debts grow.

Compound interest schedules

Interest can compound on almost any schedule, but most commonly compounds:

  • Daily (often found in CDs and savings/money market accounts)
  • Monthly (often found in CDs, bank loans and credit cards)
  • Quarterly
  • Semiannually (often found in CDs)
  • Annually

Some financial instruments also compound interest continually, or as often as possible. While that sounds like a great deal, the difference between continuously and daily compound interest is often quite small.

It’s also important to note that accruing and crediting interest aren’t the same thing. For example, many banks compound interest daily but only credit your earnings to your account once a month. Since interest must be added to your principal balance before it earns additional interest, crediting frequency also impacts your earnings.

The importance of compound interest schedules

When calculating compound interest, the number of compounding periods can drastically impact your earnings.

Consider a $10,000 deposit earning 6% interest compounded annually. After 10 years, you’d earn $22,071.35 in interest, bringing your balance to $32,071.35.

But if you compounded the same deposit monthly, your balance would increase to $33,102.04 after 10 years. That’s a difference of over $1,000.

How to calculate compound interest

Calculating compound interest is relatively simple once you know how. Though it looks intimidating, you just have to plug the correct variables into the following equation:

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

In this formula:

  • A = your final balance
  • P = your principal, or starting balance
  • r = your annual interest rate expressed as a decimal (1% = 0.01, etc.)
  • n = how often you compound interest per year (daily compounding = 365; semiannual compounding = 2, etc.)
  • t = your time period in years (1 year = 1; 6 months = 0.5, etc.)

Let’s break down this further with a couple of quick examples.

Calculating compound interest: Example 1

Say that you deposit $10,000 into a 10-year CD that earns 5% annual interest compounded daily. In this example:

  • P = $10,000
  • r = 0.05
  • n = 365
  • t = 10

So, your formula would look like this:

A = $10,000(1+ (0.05/365))(365)(10) = $16,486.65

Over ten years, your account balance would grow to $16,486.65, which comes out to $6,486.65 in interest.

Calculating compound interest: Example 2

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.

Pros and cons of compounding interest

Compound interest benefits those earning it. But if you’re generating compound interest on your debts, you’ll want to pay them off ASAP.

Pros of compounding interest

  • Works in your favor when you’re earning interest
  • Exponentially increases your account balances over time
  • Can offset the detrimental impacts of inflation and declining dollar values
  • Making smaller, more frequent payments on debts generating compound interest cuts down your long-term costs 

Cons of compounding interest

  • Works against you when you’re paying interest
  • Exponentially increases your debt balances over time
  • Compound interest earnings are taxable unless the money is stored in a tax-advantaged account
  • Not all investments earn compound interest, or else compound infrequently

How investors can use compound interest

Compound interest benefits investors in several ways.

To start, most savings accounts earn compound interest. So when you stash your emergency fund or house down payment at your bank, you can enjoy long-term compound interest on your deposits.

Certain other investments, like bonds, money market accounts and CDs also generate compound interest. You can take advantage of this knowledge by diversifying your funds across multiple interest-earning accounts to amplify your long-term returns.

That said, it’s important to remember that any investment gains generate potentially substantial tax bills. While compound interest benefits your investment strategy, knowing where to stash compound interest is essential.

Capitalizing on retirement plans

One of the best places to store interest-earning investments to maximize long-term gains is your investment accounts.

Most investment accounts, like IRAs and 401(k)s, protect your taxable returns from Uncle Sam until retirement. Depending on whether you prefer Roth or traditional accounts, you might not have to pay taxes on your earnings at all.

That gives you more flexibility to save and earn long-term – and even slash your lifetime tax bill.

The importance of starting young

Unfortunately, it’s common for younger savers and investors to neglect their accounts early on in favor of other expenses. But the longer you save, the better off you’ll be long-term.

Say that you start investing $100 a month at age 20 and earn 7% compounded monthly for 45 years. When you turn 65, your account will be worth over $381,000 – with just $54,100 comprising your contributions.

Now imagine that you start investing $200 a month at age 40 and earn 7% compounded monthly for 25 years. Despite contributing $60,200 of your own funds, your account balance will only grow to around $163,000.

In other words: even if you start small, saving early and often is more beneficial to your long-term plan.

How to open a compound interest account

The best way to take advantage of compound interest is by saving and investing. The earlier you start, the longer – and faster – your wealth can grow. It’s that simple.

One great place to start is by opening high-interest savings accounts to store your short- and medium-term savings. Bank accounts, money market accounts, and CDs can all make interest work in your favor. The key is finding accounts with minimal fees, higher APYs, and more frequent compounding schedules.

But interest rates on the best accounts still pale in comparison to the historical rate of return for the stock market, which averages 9-10% annually (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.

Earning compound interest with Q.ai

When it comes to building future wealth, it’s best to take a long-term approach to both saving and investing. But you don’t have to go it alone when you have Q.ai at your side.

At Q.ai, we harness the power of artificial intelligence to track down the best assets for our risk-adjusted Investment Kits. Each Kit targets a specific theme, idea or sector to give investors both flexibility and a powerful leg up in the markets.

But we don’t just seek any returns – we look for investments that have a chance to generate the greatest long-term compound earnings.

Better yet, we even monitor and rebalance your cumulative risk between Kits to help meet your long-term goals without jeopardizing your long-term security.

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