How Does Compound Interest Work?

Whether you’re investing money or calculating the amount of interest on your loan, you may be wondering what compound interest is and how it works? We will explain what compound interest is, as well as how it works in much detail below.

How Does Compound Interest Work?

Compound interest, commonly known as compounding interest, works by adding the interest to a principal amount, and then calculating interest on the principal amount as well as the interest that you have previously accumulated. The simplest way to explain compound interest is that it’s interest on principal + interest.

For example, if you have a savings account and you deposit $1,000 into your savings account at a 5% interest rate that’s compounded annually, at the end of your first years, you will have $1050 in your account. The next year, the amount you will earn interest on is $1050 (principal + interest) because you’ve added the interest to your principal amount.

However, if you had simple interest instead of compound interest, you would only earn interest on the initial $1,000 that you had deposited into your savings account and the interest would be set aside, you would not earn interest on your interest.

So, if you have money in your savings, you would want compound interest because it can exponentially increase the amount of money you’re saving because you’re getting interest on the principal amount that you saved, as well as interest or the interest you’ve earned.

On the other hand, with simple interest, interest is only calculated on the original principal, you will not earn interest on your interest. You can still make money, but you will not have the exponential growth that you have with compound interest.

The number of times interest is compounded depends on your financial institution. Some banks may choose daily compounding, monthly compounding, quarterly compounding, or annual compounding.

The type of compounding is different from one bank to another. For example, Bank of America and Wells Fargo compound interest on a daily basis, however, other banks, such as Chase, compound interest monthly.

The more frequently a bank compounds interest, the more money you’ll make on your savings. So, if you were to deposit the same sum of money with Bank of America and Chase at the same interest rate, you will make more money with Bank of America than you would with chase.

Compound Interest on Debt

Now that you know that compound interest is great when you’re saving money, when you’re trying to pay off debt, you do not want compounded interest. This is so because when you’re paying off debt if the interest on the debt is compounded, you will end up paying more to borrow money because you’re essentially being charged interest on a larger sum of money every month.

How to Calculate Compound Interest?

The formula for compound interest is as follows:

A = P(1+r/n)nt

  • A – Refers to the amount of money that you will have at the end

  • P – Refers to the principal amount of money that you’re starting off with

  • R – Refers to the annual interest rate you’ve been offered

  • N – Refers to the number of times your interest rate compounds every year

  • T – Refers to the total number of years you are planning on earning interest on your money

For example, If you wanted to place $10,000 in your checking account at a 5% interest for a 5 year period compounded annually, the formula would look as follows:

A = $10,000(1 + .05/1)(1)(5)

A = $12,762.82

With the same example, if your interest was not compounded, you would use the following simple interest rate formula, which would yield the following result:

A = P(1 + RT)

A = $10,000 (1 + .05 x 5)

A = $12,500

So, as you can see from the formula above, by saving money in a savings account that uses compounded interest, you will save more money ($262.82). That said, you may believe this amount is small, but as the amount of money increases, the yields will become much higher.

Note: We were compounding interest on an annual basis, the more frequently your interest compounds, the more money you’ll be earning on money in your savings account.

Why Does Money Grow More Quickly With Compound Interest?

People who are saving using a savings account that offers compound interest can grow their money more quickly than those relying on simple interest. This is so because you’re earning money on the principal amount that you’ve invested, as well as the interest that’s added to that amount. The more frequently your interest compounds, the more money you’ll be able to earn.

Some banks, such as Bank of America and Wells Fargo compound interest on a daily basis, whereas other banks such as Chase, compound interest on an annual basis. So, the bigger the sum of money that you’re saving the more money you’ll earn in the long run.

For example, if you were to place $100,000 in an account that only offers simple interest at a rate of 5% for 10 years, you would earn $50,000 in interest. However, if the same amount of money at the same interest rate were to be placed in an account with compound interest, you would earn approximately $63,000 during the same ten year period. This is an increase of over 24% in earning by simply switching to a compounding interest account instead of a simple interest account.

How Frequently Does Compounding Interest Compound?

The frequency of which your interest compounds is different from one financial institution to another. For savings accounts, most banks have adopted daily compounding, where the interest you’ve earned in any given day is added to your principal amount, allowing you to earn interest on your interest.

That said, for a CD account, interest may compound on a daily basis, monthly basis, or semi annual basis. For money market account, interest usually compounds on a daily basis. That said, to determine how often your interest rate compounds, you should contact your financial institution and ask them about your specific account.

Credit Score Planet Frequently Asked Questions

1. Is compound interest good?

If you are saving money, compound interest is a great thing to have because it can exponentially increase the growth of your money. However, if you have compound interest on a loan, you do not want compound interest because it means that you’ll end up paying more money to pay down your balance.

2. How does compound interest work?

Compound interest works by allowing you to earn money on not only the principal amount that you’ve saved but also interest on the interest you’ve earned. The more frequently that your interest compounds, the more money you’ll be able to earn.

3. How does compound interest on a daily basis work?

Compound interest on a daily basis works by adding the interest that you’ve earned on your principal balance to the principal itself at the end of each day, so that the following day you earn interest on the principal amount, as well as the interest you’ve earned in previous periods.

4. Can I double my money with compound interest in three years?

Although you may be able to double your money with compound interest, you probably will not be able to do in three years unless you have an extremely high interest rate, which is very rare.