What is Compound Interest?
Waiting until the perfect time to start building your savings nest egg could be costly. If you'd like to retire one day, or at least work less than you do now, a nonexistent or irregular savings habit will eventually bite you in the wallet.
On the other hand, starting your wealth-building journey early could mean you only need to set aside a small, consistent amount each month - and let compound interest do the heavy lifting.
What is Compound Interest?
Compound interest is the interest earnings you generate based on your initial savings deposit plus the accrued amount since your first deposit. Interest is said to "compound" when your interest earns interest, thereby helping your initial and subsequent deposits grow faster than if left to accumulate on their own.
How does Compound Interest Work?
It's often easier to understand how compound interest works when it's presented in steps.
- Step 1: Your savings balance earns interest.
- Step 2: That interest is added to the balance of your savings.
- Step 3: The next time interest is calculated, the resulting balance will be based on the total of the money you've deposited plus the interest it has already earned.
- Step 4: Then, that interest is added to your total and included the next time interest is calculated.
And the process is repeated each interest period.
How is Compound Interest Calculated?
The mathematical calculation of compound interest is rather complicated, but it can be learned. Some financial experts use the following formula to calculate compound interest:
A = P(1+r/n)^nt
Compound interest is calculated using the initial principal or deposit amount (P), the annual interest rate (r), the time period (t), and the number of compound periods within that time period (n). The result is the accrued amount (A) which is the principal plus the total interest earned.
Note: This basic compound interest formula only includes the original deposit you make into the account.
Depending on how frequently your savings balance compounds, the faster your interest earnings can grow. Interest may compound daily, monthly, quarterly, or annually. Increase the snowball effect of compound interest by saving early and often.
Why is Compound Interest Key to Building Wealth?
Compound interest can simplify wealth building since it mainly needs time and consistent deposits. You can maximize its effects by letting money stay in the account instead of making withdrawals. When you practice patience, your money can grow faster without making larger deposits to reach your savings goal. The more compounding periods, the greater gains you can experience with minimal financial effort.
Common Compounding Interest-Earning Accounts
Everyday bank accounts can quickly grow your savings with the help of compound interest. Some include:
Savings accounts offer a low-risk way to reach your financial goals. These accounts are easy to open and may compound regularly according to account terms. While you can withdraw money as needed, doing so could reduce your potential compound interest earnings. Many accounts can be opened for as little as $5.
Money Market Accounts
Money market accounts typically pay interest rates higher than savings accounts, but they often limit the number of transactions you can complete each month. They usually have additional restrictions to encourage you to leave your money in the account. As with savings accounts, withdrawing or transferring money may cause you to miss out on the potential compound interest benefits. The initial balance requirement for a money market account is typically higher than savings accounts.
Certificates of Deposit (CDs)
Certificates of deposit often pay an interest rate higher than both savings and money market accounts. Similar to money market accounts, CDs require a minimum deposit. Higher interest rates are paid on higher initial deposit amounts. In return, account holders agree to keep their money in the account for a preset period, and early withdrawals negatively affect earnings. CDs are often preferred by savers who want to earn higher interest on money they don't need right away.
Growing your investments takes time and patience. Give your long-term financial goals time to grow with less effort by making regular deposits and resisting the urge to withdraw money. Adding to your balance and letting it compound could make for a comfortable financial future.