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Compound interest is the interest you earn on both your initial savings deposit and the interest already accrued and credited to your savings balance. This is an easy way to build savings, as each interest payment generates returns on your initial deposit, even if you never deposit more funds. This snowball effect is often called “the miracle of compound interest”.
Here’s how compound interest works, how to calculate it, and how to maximize your savings:
What is compound interest?
When you have a bank or investment account that pays interest, the financial institution compounds your accrued interest and credits it to your account regularly. Since the calculation is compounded, i.e. calculated on the basis of the total balance, including interest previously credited to your account, the growth rate increases as your balance increases.
For instance: Let’s say you deposit $1,000 into a savings account that pays an annual interest rate of 1%. Your first year’s interest will be $10, bringing your account balance to $1,010. Your bank will calculate your second year’s interest based on this new balance.
This higher interest rate can make a high-yield savings account ideal if you’re saving for an emergency fund, vacation, new car, down payment, etc.
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*national average accurate as of September 2020 and subject to change.
How does compound interest work?
The following example will help you understand exactly how compound interest works. Let’s say you deposit $1,000 into a high-yield savings account with a simple interest rate of 5% (much higher than what you’ll find with a standard savings account).
- Year 2: 5% interest on $1,050 equals $52.50, bringing your balance to $1,102.50
- Year 3: 5% interest on $1,102.50 equals $55.13 (rounded), bringing your balance to $1,157.63
- Year 4: 5% interest on $1,157.63 equals $57.88, bringing your balance to $1,215.51
- Year 5: 5% interest on $1,215.51 equals $60.78 (rounded), bringing your balance to $1,276.29
If the bank had only paid interest on the initial $1,000, the account would have earned only $50 per year, or $250 after five years. Instead, it brought in $276.29.
What is the formula for calculating compound interest?
The formula for calculating compound interest can be expressed in a number of ways, but this is a common one:
Each letter in the compound interest formula represents a value:
- A: The total amount you will have at the end of the period for which you are calculating compound interest
- P: The principal amount, which is your initial investment
- A: The annual interest rate, expressed as a decimal number
- NOT : The number of times interest is compounded each year
- T: The time during which interest accrues
The formula is less complicated than it looks. You simply use values you know to determine values you don’t know.
If, for example, you want to compare savings accounts and know how much you will deposit and how long you will keep the money in savings, you have the values for (P) and
The following table illustrates how time and frequency affect the total. It assumes an initial deposit of $1,000 and an annual interest rate of 5%.
Compounds daily | Monthly compounds | Compounds annually | |
---|---|---|---|
After a year | $1,051.27 | $1,051.16 | $1,050 |
After two years | $1,105.16 | $1,104.94 | $1,102.50 |
After five years | $1,284 | $1,283.36 | $1,276.28 |
After ten years | $1,648.66 | $1,647.01 | $1,628.89 |
Note that compound interest has the same effect on debts you pay interest on, such as credit card debts. The higher the rate and the more often the interest is compounded, the faster your debt increases.
Take advantage of compound interest when opening a savings account
Compound interest is like free money that grows your savings. Here are some tips to maximize your earnings:
- Start saving early. The sooner you save, the more time your interest will have to accumulate.
- Check the dialing frequency. Frequent compounding, such as daily or monthly, generates more income than annual compounding.
- Find the highest APY. The annual percentage yield is the total interest you will earn in a year. The calculation includes both percentage rate and compounding frequency, so it is a more accurate measure than the annual interest rate alone.
Compound interest and debt
Compound interest can have a major effect on debt. Daily compounding, which is typical of credit cards, amplifies the effect and extends the time it takes you to get out of debt if you only make minimum payments.
For example, suppose you have a credit card balance of $1,000 with an APR of 15%. If you make minimum payments of $25 per month, it will take you 56 months to pay off the debt and you will pay a total of $394.98 in interest, or nearly 40% of the original debt.
When the interest rate on debt is so high that minimum payments don’t keep up with interest charges — a situation called negative amortization — you could find yourself going into debt even if you never miss a payment.
A personal loan can be a great solution for consolidating compound, high-interest debt. Personal loans have fixed rates that are often lower than credit cards and payday loans, allowing you to save on interest and get out of debt faster.
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