The complete beginner’s guide to compound interest

WeMoney

If you’re trying to save or make a solid investment, you might have come across the term “compound interest rate.” While it might sound like jargon, the concept itself is relatively simple. At its most basic, compound interest can be understood as the exponential growth of interest.

Or, the idea that money that makes money, makes more money. So, if you’ve been asking yourself the question “what is compound interest?” then this beginner’s guide should help.

Let’s get to the following commonly asked questions:

  • What is compound interest?
  • What things to consider when choosing a savings account?
  • How to make compound interest work for you?
  • How to calculate compound interest?

Q1. What is compound interest?

If you put your money into a savings account, you might expect to earn interest on your principal amount. This is what’s known as simple interest. However, find an account that can offer compounded interest, and you will also earn interest on your interest. The same can be said for other types of compounded interest bank accounts, including transaction accounts and checking accounts.

To make this a little clearer, it’s worth taking a look at compounded interest in action. Say, for example, that you opened an account with $1,000 and the annual interest rate was 5%. By the end of that first year you would have $1,050, and the following year, the interest you amass would be based on that new, higher sum.

So, since 5% of 1,050 is 52.5, the amount you would have after two years would be $1,102.50. The year after that, it would be $1,157.63, the year after that it would be $1,215.50, and so on.

Important: This works the other way, too. So, if you take out a home loan, any personal loans, or have a credit card debt on which the interest is compounded, you will end up owing more and more in loan repayments the longer the interest (and the interest on the interest) accrues.


Q2. What things to consider when choosing a savings account?

When looking around for a savings account with compounded interest, there are a few key factors worth taking into consideration. While the effects of compounding your principal sum will accelerate your earnings no matter what, things like the frequency of compounding and annual rate will impact the amount you make and how quickly you make it.

So, make sure you think about the following when doing research into the comparison rate of different accounts.

Interest rate

The most obvious thing you should look out for is what the interest rate of any given account actually is. If the interest rate is high, your daily monthly or annual earnings will grow more rapidly. However, sometimes an account with a lower interest rate that compounds regularly can be more lucrative than one with a higher rate that only accrues once a year or so.

Say, for example, you find an attractive account with a simple but high annual interest rate. While the first few times your interest grows will bring satisfying returns, your annual percentage increase could end up being lower than if you had an account that accrued less interest, but did so every single month.

Principal amount

It’s important to note that the initial deposit you make won’t impact the rate of interest offered by any one bank account. So, you could start with $1,000 or $100,000 and the rate of increase would still be the same.

Note: You will earn more money over time if you make regular deposits. You might want to consider setting up a monthly payment, in order to keep increasing the value of the sum on which you earn interest.

Frequency

After you’ve deposited your initial principal amount, it is the frequency with which your interest compounds that is most crucial. Interest that is compounded monthly is likely to make you more money over time than that which compounds annually, even if the rate of interest is lower to start with.

Then, if you set up a monthly deposit to your bank account, your earnings will grow at an even faster rate, because you’ll be adding to your interest-generating funds. Or, better yet, read up on money market accounts, many of which compound daily.

Time

Similarly important to the compounding frequency is the length of time over which you generate interest. Those who benefit from an effective annual boost to savings or other funds would be well-advised to leave their money alone (or add to it) in order to reap the most rewards. In other words, no matter how regular your compounding periods, the longer you allow your earnings to accelerate, the better.

Q3. How to make compound interest work for you?

Now that you’ve had an insight into the power of compound interest, it’s time to start thinking about how to use it to help you reach your savings goals and other financial aims faster.

Savings goals

When it comes to opening up a savings account, you can’t really do much better than one that compounds frequently. However, if you’re currently on the lookout, aim to play the long game, and balance up the short-term earnings with the longer-term benefits that any given account can offer you.

If, for example, you think you’ll need more money sooner, an account with a higher interest rate that compounds less frequently might actually make more sense for your personal finance. Regardless of the account you end up with, though, in order to really maximise your rate of return, ideally you should open up your account sooner rather than later.

Important: No matter how much you start out with, the earlier you deposit, the earlier the exponential growth of your earnings can kick in. Then, whether your account is a daily compound, an annual compound, or something else in between, you will continue to earn increasing amounts as time goes on.

Debt goals

While some people might be whipping out a savings goal calculator to see how compound interest could help them accrue more money in less time, others might be thinking about all this from a different angle.

For those that have continuous compound debts, interest rates are likely to be more of a cause for concern than for celebration. If that’s the situation you find yourself in, then aim to pay off your debts as quickly as you can, and pay off more than you need to whenever possible.

Note: By simply paying the minimum amount, all you’re doing is allowing the compound interest to accumulate virtually unimpeded.

Q4. How to calculate compound interest?

One of the most frequently asked questions about compound interest is “how do I calculate it?” Well, this is where things get a little bit trickier and a little more technical.

There is a compound interest formula that will help you figure out the future value of your principal deposit. And, it’s a good idea to learn it, because being able to calculate compound interest whenever you need to means you’ll always be able to project how much you’ll earn in a given time period.

However, if you’re not all that confident with numbers, don’t worry. You can use an online compound interest calculator to do the maths for you instantly.

The compound interest equation

You can use the following equation to work out compound interest:

A = B (1 + [ r / n ] ^ nt

In this case, A is the amount you will end up with, while P is the initial deposit you make. r is the interest rate (which you’ll need to write in decimal form) and n is how often it will be paid in a given year. Finally, t is the number of years for which your money will compound.

Enter these values into your calculator if you want to figure out the outcome of your yearly compounding interest over time.

It’s also a good idea to do this calculation when trying to decide what savings account or loan makes most sense for your financial situation. To be even more thorough, you should use it alongside a savings calculator or loan calculator.


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Disclaimer: The author is not a financial advisor and the information provided is general in nature and was prepared for information purposes only. This article should not be considered to constitute financial advice. Accordingly, reliance should not be placed on this article as the basis for making an investment, financial or other decision. This information does not take into account your investment objectives, particular needs or financial situation.

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