How Does Compound Interest Work?
Compound interest is when your money starts making money for you in the form of interest on top of interest, which is the main principle of wealth building.
What We'll Cover
- What is compound interest
- How compound interest works
- The 6 steps for taking advantage of compound interest
- When compound interest works against you
Can you imagine if your money actually made more money than you did?
Can you also imagine if they would have mentioned this to you back in high school? Chances are good you would have probably paid a little bit more attention back in math class.
The good news is compound interest is an incredible way to build wealth over time to the point where your money can actually produce more money than your working income.
But what is compound interest? How does compound interest work? How can you take advantage of compound interest and how can it also work against you?
We have a lot to cover, so let’s get started.
What is Compound Interest?
Compound interest is the interest you earn from the amount you invested (principal amount), plus the interest your investment is also earning. Yes, this sounds confusing, so another way to think about it is interest on top of interest.
Before we dive too far in, it’s important to understand the difference between simple interest and compound interest.
What is Simple Interest?
Simple interest is the amount of interest your savings earns on just the initial deposit of the investment.
To get a better understanding, let’s take a look at the formula for calculating simple interest.
Simple Interest Formula
Simple Interest Amount = (P * r * t )
P = Principal amount
r = annual rate as a percentage
t = savings time, in years
For example, if someone deposits $5,000 into an account that earns 4% (simple) interest annually for five years, the total interest earned is $1,000.
Simple Interest Amount = ($5,000 * 4% * 5 )
Simple Interest Amount = $1,000
If you deposited your $5,000 inside an account earning 4% annually for five years, you would end up with $6,000 — $5,000 principal amount plus $1,000 in interest.
How Does Compound Interest Work?
While simple interest is a wonderful thing, it can't compete when compared to compound interest. If you remember from above, compound interest is simple interest PLUS the interest your simple interest amount earns.
Think: interest on top of interest.
How does compound interest work? Let’s look at the compound interest formula to see the difference.
Compound Interest Formula
Compound Interest Amount = P(1 + r/n)n*t
P = Principal amount
r = annual rate as a percentage
n = number of times interest compounds each year
t = savings time, in years
Pro Tip: If you’re feeling overwhelmed by all the math, don't worry — we have a compound interest calculator that does it all for you.
Using the same principal amount, interest rate, and timeframe from earlier, let’s look at the difference between simple interest and compound interest in the numbers.
Compound Interest Amount = P(1 + r/n)n*t
P = $5,000
r = 4%
n = 1 (compounds annually)
t = 5 years
Compound Interest Amount = $5,000(1 + 4%/1)1*5
Compound Interest Amount = $6,083
As you can see in the example above, you come out a little bit ahead ($83) when utilizing compound interest instead of simple interest. Now this probably doesn't seem like a ton of money to get excited about. However, the magic of compound interest comes into play when you add more time to your savings.
Let’s see how simple interest and compound interest compare over time.
Simple Interest vs Compound Interest Over Time
calculations made by author
As you can see from above, it’s no wonder why Albert Einstein stated compound interest was the eighth wonder of the world. The reason why there is such a large difference in growth is because simple interest only uses the interest on the principal amount. On the other hand, compound interest utilizes both the interest on the principal amount and on the interest earned each year.
Then, when you add enough time to the formula for compound interest, things start to really grow — which is exactly why a little bit of savings today can turn into a lot of savings over time.
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How to Take Advantage of Compound Interest
Now that we have you excited about compound interest, it’s time for you to jump in and take advantage of compounding interest for future wealth building.
As you may have already noticed, compound interest works best with the more time you have. With that said, if you’re a young person reading this right now — please get started right away!
On the other hand, if you’re one of the many who wish someone would have shown you this 30 years ago, it's still better to get started late than never.
Here’s how to take advantage of compound interest.
1. Get Rid of Your Consumer Debt
Maybe you’re looking at the formula above and wondering where you are going to find $5,000 or $10,000 to put towards compound interest, right?
The reason so many either fail to start saving to build wealth or don’t save enough is because debt is holding you back. Instead of using your income to build wealth with compound interest, your income is going out in the form of debt payments.
If compound interest has you excited (and it should), then it’s time to do whatever it takes to dump your debt as soon as possible.
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2. Set Aside a Portion of Your Income
Once you have freed up a portion of your income, start socking away as much as possible towards wealth building. If you’re looking for a good number to start with, take 15% of your gross income and start saving that amount.
For example, if your income is $50,000 per year, then set aside $7,500 each year ($625 every month) to be utilized for wealth building.
3. Return Rates Matter; Save Wisely
In the above example, we used a 10% annual return every year to keep the math easy. However, the reality is you're going to be hard pressed to find a savings or investment vehicle that guarantees a 10% annual return every year for 30 years.
The good news is we can look back at past years to get an idea of what the future looks like.
The S&P 500 is widely used as the benchmark for how stocks in the United States perform. When looking back from 1957 to the end of 2022, the S&P 500 (also known as the market) has averaged an annual return of 10.82%.
This also means there were years where the market has had some wild swings – it went up 38% in 1954, down 30% in 1974, back up 31% in 1997, down 38% in 2008, up 27% in 2021 and then back down 19% in 2022. Overall, the average return is 10.82%.
You also have options for less volatility in things like savings accounts, share certificates, and certificates of deposit. However, with less volatility comes much lower returns over time.
For example, if we exchanged the 10% return from the example above for a 4% return over 30 years, your growth drops almost $62,000 (38% less)!
Compound Interest: Rate Comparisons
calculations made by author
Depending on the amount of time you have to save and invest, your risk tolerance, and your long-term financial goals will determine where to start saving and investing your money.
A great place to start is with a certified financial advisor — someone who will answer all your wealth building questions and will help you create a wealth building plan suited to your needs.
4. Start Saving as Soon as Possible
Whether you start investing in your company’s 401(k), a traditional IRA, a ROTH IRA or any other investment vehicle, the key to building wealth with compound interest is time.
As you recall from earlier, the growth on your investment isn’t much in those first few years. However, over time the interest on top of interest grows exponentially, and with enough time you will actually encounter your money making more money than your actual income.
5. Add More Each Year
When you’re just starting out, chances are you’ll only earn more money as time goes on. With that said, learn to add a little more to savings each year to really give compound interest an added boost.
It’s always a great idea to split your raise. This means every time you get a raise, split it up – half goes toward wealth building and the other half goes into your pocket.
For example, if you were to get a 10% raise, 5% goes towards wealth building and the other 5% goes in your pocket.
What does this look like?
Let’s assume you are 30 years old, your annual income is $50,000, and you just got a 10% raise, which means you’re now earning $55,000.
When you split your raise, $2,500 more goes in your pocket and the other $2,500 goes into your savings.
Now, let’s assume you get a 10% raise every five years and you continue to split your raise.
**Assuming 10% income raise every five years and compound interest 10% annually on the raise only
Splitting the raise is an incredible way to add wealth using compound interest over your working lifetime.
6. Be Patient
As time goes on, the world becomes increasingly instantaneous. We can order online and have it dropped off at our doorstep the same day. Instead of sending a letter halfway around the world, we can pick up our phones and video chat with someone 10,000 miles away in seconds.
As much as the world has moved towards the speed of light, building wealth still takes time. It’s important to be patient. Building wealth is less like a microwave and more like a crockpot – and then some.
Pay attention to your savings and investments, but there’s no need to look at them every day. Instead, keep an eye on your savings a few times a year and continue to be patient even when the markets look like the only place they can keep going is down.
As Sir Winston Churchill once said, “To understand the future, we need to understand the past.”
Those who have built substantial wealth over time were diligent and patient during both the good times and the bad.
When Compound Interest Works Against You
When we talk about compound interest, we’re typically referring to how compound interest acts like the wind at your back for building wealth.
But compound interest can also act like a fierce headwind that doesn’t seem to let up.
Now we're talking about high-interest credit cards.
Credit card issuers also utilize compound interest, but in the wrong direction for you. To make things worse, credit card rates are much higher than the average rate of the stock market. In fact, the average credit card rate as of February 2023 was a staggering 24.24% and the average return of the stock market has been 10.82% over the past 65 years – ouch!
Here’s an example of how compound interest works against you with high-interest credit cards:
If we assume you owe $5,000 at a 20% interest rate, about $2.74 would accrue on day one. The next day, the interest isn’t charged at $5,000 again, but is now $5,002.74. Remember, compound interest is interest on top of interest.
Key Takeaways
- Compound interest is interest on top of interest.
- Time is the main ingredient when it comes to compound interest.
- Compound interest is not a get-rich-quick tactic. Building wealth is a long game.
- Debt allows compound interest to work against you.
Compound interest allows you to take what seems to be a small amount of money today and grow it into substantial wealth over time. Keep in mind the main ingredient of compound interest is time.
However, if you feel it’s too late for you to get started taking advantage of compound interest, you would be wrong.
The best time to get started utilizing compound interest to build wealth was yesterday. The next best time is right now.
By Chris “Peach” Petrie,
Founder of Money Peach
Chris “Peach” Petrie is the founder of Money Peach. Money Peach partnered with OneAZ to provide free financial education to members across the state. To learn more about OneAZ’s partnership with Money Peach, click here.
APR = Annual Percentage Rate
