Compound Interest: How it Works
“Compound interest is the eighth wonder of the world. He who understands it earns it … He who doesn’t … pays it.” – Albert Einstein
Einstein called compound interest the eighth wonder of the world for good reason. Understanding this phenomenon is crucial to learning how to build wealth and make smart decisions about how to protect and grow your savings.
What Is Compound Interest?
When you save money in an account, you earn interest. When you owe money on a credit card, you have to pay interest. That interest can be calculated in one of two ways.
To define each type of interest, it helps to see it in action. As an example, let’s say we want to put aside $500 to grow at a 3 percent interest rate.
If you earn 3 percent simple interest per year, you collect $15 per year. Therefore, after three years, you will have $545.
With compound interest, your interest payment is calculated using the principal plus any interest already earned. So, at a 3 percent rate compounded once per year, you still earn $15 the first year. In year two, however, you earn 3 percent interest on not just your initial $500 but on the new total of $515 [principal ($500) + interest earned in year one ($15)]. So instead of just $15.00 in year two, you earn $15.45. In year three, you earn 3 percent on the new total — $530.45. So after three years of compound interest, you’ll have $546.36.
That’s only a $1.36 difference over three years, but the effects of compound interest are exponential. Tracked on a graph, this kind of growth resembles the blade of a hockey stick swooping upward. Watch what happens to the same $500 over 20 years:
4 Years: $562.75
5 Years: $579.64
6 Years: $597.03
7 Years: $614.94
8 Years: $633.39
9 Years $652.39
10 Years: $671.96
15 Years: $778.98
20 Years: $903.06
You get an idea of how fast money can grow in the example above, but that’s only $500 dollars left in an account to collect interest. If you add to your savings regularly over that 20 years, you earn even more interest.
Want to see how compound interest can affect the cash that you have saved? Try the compound interest calculator at investor.gov to see the power and potential of starting a savings or other interest-bearing account today.