Compound Interest Guide: Pros and Cons of Compound Interest

Compound interest, or compounding interest, is interest earned from the original principal amount of a deposit or investment, plus any accumulated interest from prior earning periods. Compound interest is also known as “interest on interest” because when investors opt to keep accrued interest in their account rather than withdrawing it, the interest becomes part of the principal where it can then earn more interest.

The rate at which it accrues is the annual equivalent rate or annual percentage yield (APY), which is based on the compounding period, or the time in which compounded interest is regularly capitalized, or credited to the initial principal. The number of compounding periods varies: there can be annual compounding, monthly, or semi-annual, which is often used with certificates of deposit (CD).

The daily compounding schedule is most frequently used for savings accounts, money market accounts, and even continuous compounding, in which compounded interest is constantly added to the principal. The compounding frequency often depends on which financial products generate interest. Still, the rule of thumb in finance is that the higher the number of compounding periods, the greater the interest.

Compound interest works in the following manner:

1. 1. Deposit funds into an account. A deposit into a bank account or investment account, such as a high-yield savings account, money market accounts, or a zero-coupon bond, can generate compound interest. Stock market investments can also gain compound interest if they pay dividends.
2. 2. The deposit generates interest. The account will generate interest, which is often accrued at a yearly rate. For example, a deposit of $1,000 into an annually compounded savings account with a 5 percent APY will result in a balance of $1,050 by the end of the first year.
3. 3. The initial interest is compounded. The APY generates interest on both the principal amount and interest amount from the first year. Based on the previous example, the total interest would be $52.50. By the end of the second year, the total amount is $1,102.50.

There are several ways to calculate compound interest, including:

1. 1. Compound interest formula: You can use several mathematical formulas to calculate compound interest. One of the most straightforward formulas for interest calculation is the fixed formula: A = (PV(1+i)n - P. In this equation, “A” is the final amount, “PV” is the present value of the principal amount, the “i” is the interest rate expressed as a decimal percentage, “n” is the number of times the interest will compound. To solve the interest calculation, add one to the interest rate percentage, multiply the new percentage by the length of time and multiply that amount by the present value to get the annual return. Subtract the annual return from the principal to determine the compound interest rate.
2. 2. Compound interest calculator: Many calculators—both hand-held models and computer programs—have exponent functions that can help you calculate compound interest rates. There are also free online calculators, including one operated by the U.S. Securities and Exchange Commission.
3. 3. Spreadsheets: Spreadsheet applications typically feature a future value calculation function that investors can use to calculate compound interest. The future value is the monetary value of a sum at a later date, which can ascertain the future worth of the principal investment based on accumulated interest and interest payments.
4. 4. The rule of 72: The rule of 72 is a simple formula that you can use to determine the number of years required to double an investment by dividing the annual interest rate by 72. For example, if the rate of return is five percent, an investment will double in approximately 14 years (72/5 = 14.4).

Compound interest has its share of advantages for consumers and financial institutions alike. The power of compound interest lies in its so-called “snowball effect,” which is a metaphor that compares its ability to build wealth over time to a snowball growing in size and mass as it rolls down a hill.

Even minor investments can, over time, yield major returns with compound interest. The snowball effect is particularly beneficial for investors who begin saving in their twenties. While they will initially save less due to regular investments, they will also have a great deal of money by the time they retire.

One of the downsides to compound interest is that its benefits apply to financial institutions and consumers. Lenders and credit card issuers can apply compound interest to the repayment of student loans and credit card debt. This interest can grow out of control over time, especially for consumers paying the minimum monthly amount on these bills.

Compound interest is always calculated before you make a payment, and not after you’ve sent in your payment. If you are paying interest regularly and are either late or miss a payment, your rate of return can decrease and cost you money.

The difference between compound interest and simple interest lies in the way in which the interest is generated. Simple interest is calculated annually, based only on the loan or debt principal amount, and typically applies to mortgages, personal loans, or credit card balances.

Borrowers benefit from simple interest since they are only paying interest charges on the principal. Investors benefit more from compound interest because it can help their initial investment grow over several years.

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