What is compound interest?

Compound interest is interest that accrues on your principal and interest. Compound interest builds on the original principal, which is the initial amount you invest or save. Put simply, that means the interest you earn is earning interest on itself, which can dramatically impact your balance over time.

Understanding how compound interest works can help you make more money over time—or avoid paying more in interest. However, while compound interest can dramatically increase your balance, it’s important to consider inflation, which can affect the real value of your returns over time.

What is compound interest?

Compound interest is the interest you earn from your principal savings or investment amount plus any interest the investment earns. Consequently, your account earns interest on top of interest.

This is different from simple interest, which is interest that accrues solely on your principal balance; you don’t earn any additional interest on your interest gains. The earlier you start, the more time your money has to benefit from compounding, making it crucial to start early to maximize your returns.

Compound interest is important because with savings and investments, it enables your money to grow exponentially. The value of your investment increases significantly over time due to compounding, as reinvested interest or dividends contribute to the total accumulated value. Whereas simple interest only allows you to earn interest on your initial investment, compound interest triggers a faster growth rate.

The tricky thing about compounding interest is that it can be good or bad, depending on which side you’re on. If you’re an investor, compound interest helps investors maximize long-term growth by allowing their investment value to grow faster; if you’re a borrower, compound interest makes borrowing more expensive.

How does compound interest work?

Compound interest is the extra interest you earn on the interest that you’ve already earned, and it is calculated based on several key factors. To better understand how compound interest works, here are the primary factors at play:

• Principal balance: This is the starting balance for your savings account or investment plus any additional contributions you may make. Compound interest applies to many types of bank accounts, such as savings accounts. On a loan or credit card, it’s the current balance minus interest charges.

• Interest: Interest is effectively the cost of borrowing money. In a savings or investment account, you can earn interest from the financial institution. Financial institutions set the interest rates and are responsible for disclosing key information. With a loan, on the other hand, you pay interest to the lender.

• Compounding frequency: This feature, also called compound frequency, indicates how often interest is added to the account. The compounding period is the interval at which interest is calculated and added to the principal. The number of periods per year (such as daily, monthly, quarterly, semi-annually, or annually) affects the total interest earned, with more frequent periods generally resulting in greater compound growth.

• Duration: The longer you leave money in a savings or investment account, the more interest you’ll earn. However, the opposite is also true for debt. For example, paying just the minimum amount due on your credit card instead of paying it off can result in ballooning interest charges due to compounding interest.

• Deposits and withdrawals: The more you put into your savings or investment account, the greater impact compound interest will have on your interest earnings. Regular payments into the account can increase the impact of compounding, while fees can reduce the overall return. However, taking money from the account can reduce the impact of compound interest. Meanwhile, adding more to your credit card balance can result in increasing interest charges, while paying down your balance will do the opposite.

Simple interest vs. compound interest

While compound interest applies to both the principal balance and previously accrued interest, simple interest only accrues based on the principal balance.

As an example, let’s say you invest €10,000 in an investment that earns 10% a year in interest. Here’s a comparison of the two options to show how impactful compound interest can be:

As you can see, the compounding interest on your initial deposit grows exponentially.

Notice the difference between the first and second year: in the second year, you earn interest not only on your original €10,000 but also on the €1,000 interest from the first year, resulting in €100 more than simple interest. This difference becomes even more pronounced over time, as compounding leads to much greater returns compared to simple interest.

Whilst the benefits of compounding may seem small in the short term, they become much more significant over longer periods. As a result, compound interest is better for savings and investment accounts, while simple interest is preferable on a loan.

How to calculate compound interest

The massive growth resulting from compound interest can seem magical, but in reality, it all boils down to a simple mathematical formula known as the compound interest formula, which is used to calculate future values of investments:

A = P × ( 1 + r/n )^(n×t)

• A = The final amount of money you will have (or owe) at the end of the time period, also known as the principal sum after compounding.

• P = Your initial principal, principal amount, or how much you first invested or owed.

• r = The annual interest rate or annual rate, expressed as a decimal. For example, if your interest rate is 4% per year, you would enter 0.04 into the formula here.

• n = The number of times interest is compounded per year (times interest is added).

• t = The number of years the money grows.

This formula is used to calculate interest over time, and the result is calculated by applying the formula to your principal amount and compounding periods.

The effective annual rate reflects the true yield of an investment after accounting for compounding, making it useful for comparing different financial products. The total interest earned is the difference between the final amount (A) and the principal sum (P), and accumulated interest is added to the principal each compounding period, accelerating growth.

The rate of return can also be calculated using this formula to compare different investments and their profitability.

Compound interest example

If you’re not a maths person, you can easily use a compound interest calculator or other online calculators to get an estimate of the interest you can earn through compounding.

These calculators allow you to input different variables, such as regular deposits, total deposits, and compounding periods, to see how your investment could grow. However, crunching the numbers on your own can help you get a better understanding of how compounding works.

Let’s return to the example above and break down the results after two years using the formula:

A = €10,000 (1 + 0.1/1)1*2

A = €10,000 (1.1)2

A = €10,000 x 1.21

A = €12,100

If you make regular contributions or regular deposits, your total deposits will increase, and the final amount will be higher. Regular payments into the account can also increase the total interest earned over time.

As you compare different investment options and savings accounts, you can plug in different variables, such as interest rates, compounding frequencies, and payment schedules, to see how your result changes.

Consider factors like investment returns and other investments as well. Note that actual returns may vary year to year due to market conditions.

As an example, here’s a quick comparison of different compounding frequencies:

This table shows how frequent compounding and more frequent compounding periods, such as being compounded monthly, can significantly increase your total interest and investment growth compared to less frequent compounding periods. Each compounding period—whether annual, quarterly, or monthly—affects the final outcome, with more frequent compounding leading to higher returns.

Examples of compound interest

There are many different types of financial accounts that offer compound interest on your investment or savings. In contrast, most loans charge simple interest, albeit with some exceptions.

Here are some places where you might encounter compound interest:

• Savings deposit accounts: Whether it’s a traditional or high-yield savings account, money market account or certificate of deposit, you’ll likely earn compound interest on your balance. High yield savings accounts, in particular, are a great option for maximizing returns due to their higher annual percentage yields (APYs). In some cases, banks and credit unions compound interest as often as daily.

• Pension accounts: Accounts like pensions use compound interest to help your retirement savings grow over time. Regular contributions and early saving can make a significant difference, as money saved early has more time to benefit from compounding.

• Bonds: When you buy individual bonds or invest in a bond fund, you’re essentially lending money to the bond issuer. In exchange, you’ll earn interest on your investment. Bonds often compound interest on a semi-annual basis. Options include Treasury securities, municipal bonds and corporate bonds, along with exchange-traded funds and mutual funds that contain bonds.

• Credit cards: Credit card issuers typically charge compound interest on your balance with a daily compounding frequency. However, the good news is you can avoid interest charges entirely if you pay your balance on time and in full every month.

Note that you can also compound your earnings on other types of investments, such as stocks, exchange-traded funds, mutual funds and real estate investment trusts, if you reinvest dividends earned. While you’re not technically earning interest on these investments, investing in the stock marketallows your returns to compound over time, which is a key strategy for long-term wealth accumulation.

For example, money saved and invested early in your career can grow substantially through the power of compounding, especially when left untouched for many years.

Keep in mind that fees, such as service fees or management fees, can reduce the benefits of compounding. It’s wise to seek professional advice from a qualified financial advisor when choosing financial products or planning your investment strategy.

How to benefit from compound interest

The accelerated growth from compound interest can generate passive income you don’t have to work for. Consider the following strategies to maximise your gains through compounding interest:

• Start saving early. The longer you invest your money, the more opportunity it has to compound and grow. Saving early is especially important for retirement and investing goals, as it allows your savings to benefit from compounding over a longer period.

• Minimise withdrawals. Withdrawing money reduces your principal and, consequently, your returns. Try to avoid taking money out of your savings and investment accounts to cover unnecessary expenses.

• Regularly contribute to your account. Making regular deposits and payments into your savings or investment account increases your total deposits over time, which amplifies the effects of compounding. Consistent contributions are key to building wealth and reaching long-term goals like retirement.

• Shop around. Take your time to evaluate savings and investment options to maximize your chances of getting the best return possible. In addition to interest rates, it’s also important to compare compounding frequencies, withdrawal penalties and other features that are important to you.

• Pay off high-interest debt. While most forms of debt typically use simple interest, credit cards typically compound the interest you owe. If you have some credit card debt, take steps to pay it off as quickly as possible to minimize your interest costs. Then, make it a priority to pay in full every month to prevent further interest charges.

Compound interest can help you increase your savings and build wealth over time. However, it can also be a detriment to your financial well-being if you have high-interest credit card debt.

Take some time to evaluate your current financial situation and goals to get a better idea of how to make the most of compound interest for your financial plan.