Takeaways
- Compound interest is interest on your initial principal plus accumulated interest.
- Compound interest grows savings or debt at an exponential growth rate.
- Compound interest can be compounded daily, monthly, quarterly, or annually.
- The more compounding periods, the faster your funds grow over time.
- Compound interest grows savings and debt faster for investors and borrowers.
What Is Compound Interest?
Compound interest is the interest payment made on the original amount of your savings, called the principal amount plus previously paid interest in the account. It is colloquially known as “interest on interest” because the amount of the interest payment changes from period to period instead of being a fixed amount on the original principal amount.
Simply put, compound interest is the interest income you make as your money grows. Compound interest is unique and highly attractive to investors (and borrowers) because your funds grow exponentially. Exponential growth is the growth rate that becomes more rapid in proportion to the growing total number or size.[1] Therefore, as your principal and accumulated interest grow, your interest payments balloon as the base of principal and accrued interest build.
Harnessing compound interest is a way to work smarter with your money, not harder. You can earn more income as your savings and investments grow over time. Depending on the annual percentage yield in your checking or savings account and the number of periods per year your bank makes interest, you can make some serious interest income if you leave your funds untouched.
Take the Next Step:
Member FDIC
Quontic High Yield Savings Account
Smart Money Rating: 5/5
APY: 4.50%
Required Minimum Balance: $100
How to Calculate Compound Interest
You can use Smart Money’s Compound Interest Calculator to help calculate how much money you will earn.
However, it is important to understand the underlying mechanics of calculating compound interest so that you know how the equation variables relate to one another. This will help when researching the best savings account, checking accounts, or other investments.
Here is how the compounding formula works: A = P (1+r/n)^nt
A = Ending Balance
P = Principal Balance (or original balance)
r = Interest rate (Annual percentage rate expressed as a decimal)
n = Number of periods interest compounds in a set time frame
t = Time Frame (daily, monthly, quarterly, annually)
You might be staring blankly at your screen. Don’t worry; this formula will make more sense when we use an example to demonstrate how the compounding formula works. It's easier than it looks. Let’s look at a real-world example:
You have saved a $3,000 emergency fund and are looking for the best high-yield online savings account. You found an account that earns 4% APY and compounds interest monthly. You want to know how much money you will earn if you leave your funds in this account for one year. Here is how your variables would be assigned to the equation:
A = To be Determined
P = $3,000 (original balance)
r = .04 (Annual percentage rate expressed as a decimal)
n = 12 (compounds monthly for one year; the periods are calculated as 12*1=12)
t = 1 (year)
A = $3,000*(1+(((.04)/(12)))^(12*1)
A = $3,122.22
By choosing to help your funds accumulate interest, you would have turned $3,000 into $3,122.22 without lifting a finger.
Smart Tip:
Investors flock to high-yield savings accounts because they earn interest income, have low investment risk, and keep their funds liquid. If you invest with a product protected by the Federal Deposit Insurance Corporation (FDIC), your funds are insured even further.
Products That Use Compound Interest
Compound interest is used in everyday financial products to facilitate day-to-day transactions or finance large purchases. Importantly, compound interest is not limited to investment products but applies to funds you borrow from a bank, credit union, or other financial institution.
Take the Next Step:
Member NCUA
Alliant Credit Union CD
Smart Money Rating: 5/5
APY: 5.10 % (Terms Apply)
Required Minimum Balance: $1,000
How to Accelerate Compound Interest
Compound interest will help you reach your financial goals faster than simple interest. A key variable makes compound interest all that more potent: regular contributions.
Revisiting our example above, if you make steady contributions to your emergency fund or slush fund, you will expand and build the base (principal + interest) on which compound interest is calculated.
You can automate your finances to ensure regular contributions of $100, $200, or $300 to your checking or savings account. These contributions you drip into your account over time will catalyze your compound interest.
Smart Summary
Compound interest is evangelized by investors, regular savers, and financial independence retirement enthusiasts for its magic-like ability to accelerate savings over time. When building your investment portfolio, you should consider the annual percentage yield of your investments, compound interest rate, diversification, and desired risk profile. Taking advantage of compound interest is a smart money move because it can help you reach your financial goals faster.
(1) Oxford Reference. Exponential Growth. Last Accessed January 19, 2025.
