Earning interest on both your initial deposit and interest earned thus far is known as compound interest. Consider it the process by which your money generates income.
Consider a $1,000 deposit, for instance, with an annual percentage yield (APY) of 5%. You would receive $50 in interest (5% of $1,000) at the end of the first year. You make interest on $1,050 in the second year, which is equal to your original $1,000 plus $50 in interest. Over time, this cycle will continue, speeding up the growth of your money.
This investment will be worth -
| Year | Starting Amount | Annual Contribution | Total Contribution | Interest Earned | Total Interest Earned | End Balance |
Let’s say you want to put $10,000 into a high-yield savings account with a 4% annual yield, compounded daily. You don’t plan to add additional funds after your first deposit. To calculate earnings, here’s what you would enter into the calculator above:
- Initial deposit: $10,000.
- Years of growth: 1. (Start by entering “1”, then you can increase this to see how much you can earn over more years.)
- Estimated rate of return: 4%.
- Compound frequency: Daily.
- Contribution amount: $0. (Since you won’t be making additional contributions, enter “$0” in the field.)
- Contribution frequency: Ignore this field.
After one year, you’ll earn $408.08 in interest.
If you left your money in that account for another year, you’ll earn $424.74 in interest in year two, for a total of $832.32 in interest over two years. You earn more in the second year because interest is calculated on the initial deposit plus the interest you earned in the first year.
After 10 years, you will have earned $4,917.92 in interest for a total balance of $14,917.92.
But remember, this is just an example. Savings account APYs are subject to change at any time. For longer-term savings, there are better places than savings accounts to store your money, including Roth or traditional IRAs and CDs.
What is Compound Interest?
The cost of using borrowed funds, or more precisely, the sum that a lender gets paid for making an advance to a borrower, is known as interest. The borrower will typically pay a portion of the principal (the amount borrowed) in interest. There are two types of interest: simple interest and compound interest.
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Simple interest, which is typically expressed as a predetermined percentage of the principal, is interest generated solely on the principal. Simply multiply the principle by the interest rate and the number of periods the loan is in effect to calculate the interest payment. For example, if one person borrowed $100 from a bank at a simple interest rate of 10% per year for two years, at the end of the two years, the interest would come out to:
$100 × 10% × 2 years = $20
Simple interest is rarely used in the real world. Compound interest is widely used instead. Compound interest is interest earned on both the principal and on the accumulated interest. For example, if one person borrowed $100 from a bank at a compound interest rate of 10% per year for two years, at the end of the first year, the interest would amount to:
$100 × 10% × 1 year = $10
At the end of the first year, the loan’s balance is principal plus interest, or $100 + $10, which equals $110. The compound interest of the second year is calculated based on the balance of $110 instead of the principal of $100. Thus, the interest of the second year would come out to:
$110 × 10% × 1 year = $11
The total compound interest after 2 years is $10 + $11 = $21 versus $20 for the simple interest.
Because lenders earn interest on interest, earnings compound over time like an exponentially growing snowball. Therefore, compound interest can financially reward lenders generously over time. The longer the interest compounds for any investment, the greater the growth.
As a simple example, a young man at age 20 invested $1,000 into the stock market at a 10% annual return rate, the S&P 500’s average rate of return since the 1920s. At the age of 65, when he retires, the fund will grow to $72,890, or approximately 73 times the initial investment!
While compound interest grows wealth effectively, it can also work against debtholders. This is why one can also describe compound interest as a double-edged sword. Putting off or prolonging outstanding debt can dramatically increase the total interest owed.
Compounding Investment Returns
When you invest in the stock market, you don’t earn a set interest rate, but rather a return based on the change in the value of your investment. The value of your investment could go up or down. When the value of your investment goes up, you earn a return.
When the returns you earn are invested in the market, those returns compound over time in the same way that interest compounds.
If you invested $10,000 in a mutual fund and the fund earned a 6% return for the year, it means you gained $600, and your investment would be worth $10,600. If you got a 6% return compounded annually for two years, your investment would be worth $11,236.
In reality, investment returns will vary year to year and even day to day. In the short term, riskier investments such as stocks or stock mutual funds may lose value. But over a long time horizon, history shows that a diversified growth portfolio can return an average of 6% annually. Investment returns are typically shown at an annual rate of return.
The money can add up: If you kept the funds in a retirement account for over 30 years and earned that 6% average return, for example, your $10,000 would grow to more than $57,000.
Compounding can help fulfill long-term savings and investment goals, especially if you have time to let it work its magic over years or decades. You can earn far more than what you started with.
