Understanding Compound Interest

Compound interest is a fundamental financial concept that profoundly impacts savings, investments, and loans. Here's an overview:

Basic Principle

Compound interest is the interest you earn not just on your original principal (the initial amount) but also on the added interest earned over time. In other words, it's "interest on interest," and it allows your money to grow at an accelerating rate.

Simple vs. Compound Interest

To understand compound interest, it's helpful to differentiate it from simple interest:

  • Simple Interest: This is calculated only on the principal or on the portion of the principal which remains unpaid. For instance, if you invest $1,000 at a simple percentage annual interest rate of 5%, you'll earn $50 each year indefinitely.
  • Compound Interest: This involves earning interest on both the principal and the accumulated interest. Using the same example, with a 5% compound annual interest rate on a $1,000 investment:
    • First year: $1,000 + ($1,000 * 5%) = $1,050.
    • Second year: $1,050 + ($1,050 * 5%) = $1,102.50.
    • And so on.

Factors Influencing Compound Interest

  • Principal: The initial amount of money.
  • Rate of Interest: The interest is calculated at this percentage.
  • Compounding Frequency: How often interest is calculated and added back to the principal. It could be annually, semi-annually, quarterly, monthly, daily, etc. The more frequent the compounding, the greater the amount of compound interest.
  • Time: The length of time the money is invested or borrowed.

Use the calculator below to explore the impact of compound interest and its role in your long-term savings strategy.

Turning on "Power Mode" will display the results of the calculations alongside the input fields. When "Power Mode" is off, descriptive information sits alongside the input fields for a more informative learning experience.
Savings Information
$
Savings amount is the dollar amount of savings to evaluate over the evaluation period.
%
The Interest rate is the rate you will receive on your savings deposit, otherwise known as an APY, or Annual Percentage Yield.
The Evaluation period (years) in years, over which to analyze the effects of different compounding methods.
Compounding frequency indicates how often the interest on your investment is calculated and added back to your principal amount. Common frequencies include daily, monthly, quarterly, or annually.

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Compound Interest Summary

Compounding Interest Summary

Compound interest is a powerful force when saving or investing money. Over long periods, even a modest interest rate can lead to significant growth due to the compounding effect.

On the flip side, it's crucial to understand how compound interest works when taking on debt. Compounded interest can make debts grow faster, making them harder to pay off if you make only minimum payments.

Compound interest can be a saver's best friend and a borrower's adversary. The key takeaway is that small, consistent investments (or repayments in the case of debt) can lead to significant results over time due to the nature of compounding. It is often why financial experts emphasize the importance of starting to save or invest early. The longer your money has to compound, the more you can benefit from the "magic" of compound interest.