How Does Compound Interest Work?

Have you ever found yourself in a conversation where someone shares tips on saving and investing, using terms like “compound interest?” If that’s happened to you, you might have left the discussion feeling the need to Google “how does compound interest work?” You’re certainly not alone in this experience. 

In this article, we’ll share everything you need to know about how compound interest works to help you understand the power of compound interest and utilize this financial principle to save, invest, or pay off your debt. 

What is Compound Interest and How Does it Work? 

Compound interest includes both the interest on the original amount (also known as the principal) as well as the accrued interest that accumulates over time.

For investment or savings accounts that have a compound interest, this means that the longer your money is saved or invested, the more interest or growth you’re rewarded with.

For debts and loans, the opposite is true — the longer you take to pay off a loan, the more compound interest is applied, making the total amount you owe grow over time. 

Compound Interest Explained 

So, how does compounding interest work? Compound interest happens when the interest you earn is added to the money you saved or invested. Then, over time, you start to earn interest on the original amount of money and the interest you’ve already earned — so your money grows without adding another penny.

Let’s say you open a savings account with a 5% interest rate and contribute $100. The bank then takes your original $100 and rewards you 5% of your $100 at a set frequency period. For this example, we’ll say the set frequency of the interest you earn is once a year. After 12 months, your original $100 is now $105. 

The extra $5 may not seem like much at first, but as you keep earning interest on your growing balance, the more your money will grow. This is the power of compound interest. 

Compounding Interest Period

The compounding interest period is when interest is calculated by the bank and applied to your current balance. While you have no control over the compounding period, you can choose an account with various compounding periods, like a savings account, mutual fund, or a certificate of deposit (CD). 

Compounding Period Frequency 

The compounding period frequency is how often your bank calculates and applies interest to your money. The more often your bank adds interest, the faster you earn interest on both your original balance and the interest that has already been added. Here’s how often compounding interest might occur:

• Annually: Once a year
• Quarterly: Once every three months 
• Monthly: Once a month
• Daily: Every day for 365 days

Compound Interest Loans

You might be surprised to learn that you’re probably already familiar with the concept of compound interest, especially if you have a loan with compound interest. But instead of earning extra money, you’re paying the amount you borrowed and any accrued interest. 

Here are some of the most common types of compound interest loans:  

• Mortgage Loans: Certain mortgage loans, like an adjustable-rate mortgage, may involve compounding interest. 
• Credit Cards: Every time you carry a credit card balance, interest is compounded daily, leaving you owing more money the longer you take to pay it off. 
• Auto Loans: Most auto loan lenders use simple interest, but some use compound interest to increase the total costs. 
• Student Loans: Some private student loans use compound interest, adding more to your original repayment amount. ‍
• Personal Loans: Some personal loans have different compounding frequencies, leaving you with a larger balance to pay off.  

Types of Compound Interest Savings Accounts 

So, how does compound interest work in your favor? Well, the answer is to open a compound interest savings account. Here are some of the most common types of accounts to consider when sitting back and watching your money grow. 

High-Yield Savings Account

Opening a high-yield savings account is a smart choice if you’re looking for a safe way to grow your savings. Unlike applying funds to a traditional savings account, a high-yield savings account allows you to earn money faster at a higher interest rate without adding an extra penny (unless you’d like to).

Money Market Accounts

Money market accounts are a great option if you’re interested in earning more money than a standard savings account. The only downside to a money market account is that it requires a higher minimum balance. But, in return, compound interest is compounded daily or monthly — helping you reach your financial goals a lot faster. 

IRA Accounts 

Hoping for an early retirement? Consider opening an individual retirement savings account (IRA). While most IRAs are primarily an investment, there are some IRA savings accounts with compound interest that can make your dream of an early retirement a reality. 

How to Calculate Compound Interest 

Calculating compound interest is easier than you might think. You can find an online calculator or perform your calculation with a basic formula in Google or an Excel spreadsheet. 

Formula: A= P x (1 +  r/n​)nt

A = amount of money accumulated after interest 

P = principal amount

r = yearly interest rate written as a decimal

n = number of times the interest is compounded per year

t = number of years

Tools for Calculating Compound Interest 

If you prefer a faster and easier way to calculate compound interest, several online tools are available. Do a quick Google search until you find one you like. Then, enter the principal amount, interest rate, time period, and compound frequency to calculate the total interest. 

Pros and Cons of Compound Interest 

Like any financial principle, there are always pros and cons. Let’s break down the pros and cons of a compound interest savings account.

Benefits of Compound Interest

By opening a compound interest savings account, you can:

• Earn a passive income
• Watch your savings or investments grow
• Experience the joy of saving money
• Outpace inflation 
• Build wealth

Disadvantages of Compound Interest

There are several advantages to the principle of compound interest, especially if you have a compound-interest loan. These include: 

• Slower growth with a lower interest rate 
• Can take longer to pay off debt 
• Inflation can reduce the value of your savings
• Earnings from compound interest are taxable

Compound Interest vs Compound Returns

Compound interest and compound returns grow your money over time but are used for different financial situations. 

What are Compound Returns?

Compound returns are primarily used for investments. When you invest money like stocks or a retirement fund, you earn interest not only on your original investment but also on the interest you’ve already gained over time. 

For example, say you invest $1,500 with a 5% return rate. After one year, your original $1,500 will turn into $1,575. Then, the following year, you’ll earn 5% on the $1,575, not just the original $1,500. 

How Do Compound Returns Differ From Compound Interest? 

While compound returns and compound interest can work in your favor, compound interest can also work against you, especially if you’re in debt. However, the more you understand how compound interest works, the more you can plan to meet your financial goals. 

How to Use Compound Interest to Your Advantage

Now that we’ve answered the question, “How does compound interest work?” and covered the types of accounts you can open to grow your savings, let’s discuss how you can use compound interest to your advantage. 

Invest Early 

Everyone is at a different point in their financial journey, but the secret to building wealth is to develop and stick to smart financial habits like investing early. The earlier you invest, the more money you’ll grow. Even small contributions in your early 20s pay off thanks to the power of compound interest. 

Diversify Your Savings

Diversifying your savings accounts is one of the best ways to lower your risk and protect your money. Instead of investing all your money in a high-yield savings account, consider a mix of compound interest accounts to earn a higher return and keep your money safe. 

For example, use a high-yield savings account to grow your emergency fund while investing in stocks and retirement accounts. This is just one example of how you can save and earn money. 

Shop Around for the Best Rate Possible

The economy plays a significant role in how fast your money can grow. If interest rates are down, compare interest rates from various banks to find a higher high-yield savings or money market account. Consider switching to an account that offers high interest rates. 

Take Control of Your Financial Future Today

The next time you’re in a conversation and someone asks, “How does compounding interest work?” you won’t need to turn to Google for help; you’ll already know because you understand the power of compound interest. 

Ready to take control of your financial future? At Check City, we offer tools and resources, including payday loans, to help cover short-term expenses between paychecks. If you’re facing an unexpected cost and need a short-term financial option, we’re here to help with transparent terms and fast services.