What we'll cover:
You know that feeling of earning interest on your deposit account? Specifically, when you’re earning interest on interest previously earned – and at a recurring frequency?
Feels great, right? Almost…effortless? There’s a name for that financial concept: compound interest.
You need to know how to calculate it. How it helps you over time.
And the good ol’ Rule of 72.
Let’s break down compound interest one step at a time:
Provided you don’t touch that money, each year you start with more than you had the year before, as it continues to grow.
The saying ‘time is money’ applies to compound interest, which is what makes it one of the most powerful concepts in personal finance.
There are two compound interest formulas we’ll show. The first is for the initial deposit plus the interest earned for an account balance in which the interest is compounded annually.
A = P (1 + r/n)(nt)
R= interest rate per year
N= number of times interest is compounded per unit
Seem unnecessarily complicated? We agree, so let’s put real numbers in it to make it a little more digestible.
Let’s say you’re depositing $10,000 into a high-yield savings account that has a 2.15% APY and you plan to keep your money in for 5 years.
10,000(1+.0215/1)^(1x5) = 11,122.
You put that $10,000 into a high-yield savings account for a five year term at a 2.15% APY.
In the first year, you’ll earn $215 in interest, which means you'll end the year with a balance of $10, 215.
Then the next year, say you still have a 2.15% APY, but there’s a difference: Your starting balance is $10,215 instead of $10,000. This very same 2.15% APY on $10, 215 will give you $220 in interest, and you'll finish the year with a balance of $10, 435.
After five years, you’ll end up with a balance of $11,122, having earned $1,122 in interest just by keeping your money put.
Not bad, right?
Chart assumes an interest rate of 2.15%
Chart assumes no withdrawals or additional deposits.
How are they different? Simple interest is interest earned only on a principal amount of money.
Using the example above, if you only earn simple interest you will still get 2.15% but the amount of money that you earn that rate on will remain fixed.. In your second year, you don’t get the boost of having your starting balance higher than it was in the first year. Based on our example above, $10,000 that is earning simple interest at a rate of 2.15% over a 5 year period would yield $1,075 in interest – or $47 less than if compounded.
Simple interest formula: $10,000 x .0215 x 5 = $1,075 in interest.
Don’t just take our word for it. Albert Einstein reportedly called it the “eighth wonder of the world”, and you may hear financial advisors refer to the “power of compounding.” Keep in mind that interest can compound at different frequencies, commonly daily, monthly, or annually as determined by a bank or financial institution. The more frequently it compounds, the faster it grows.
Ever wonder how many years it takes for you to double your money with compound interest? This is where the Rule of 72 comes into play.
Here’s the formula:
72 ÷ annual interest rate (APY) = approximately how many years it takes for your money to double
Let’s plug in some numbers. Let's say you put $10,000 into a CD with a 3% APY. If your interest remained constant at 3% a year and left all of your money in for the full term, how long would it take for you to double your money?
72 ÷ 3 = 24
This shows it’ll take about 24 years to turn your original $10,000 into $20,000. Here's one caveat: the Rule of 72 only gives you an estimate.
The power of compounding can have an impact on many parts of your financial life. Now that you understand what it is and how it works, you can use this knowledge to help make your money work for you. You can start compounding interest today with a Marcus Online Savings Account.
Given the above examples, the pros of compounding interest have to do with your high-yield savings accounts and CDs that can grow faster than if they were earning simple interest.
However, there can be cons to compounding interest.
Just like how your money grows faster in a high-interest savings account or a CD, your credit card debt grows faster when the amount you owe in interest compounds. This can lead to a cycle of credit card debt. If you’re thinking about consolidating credit card debt, here’s a personal loan calculator that can help you determine if a personal loan could be a good option for you.