What Exactly Is Compound Interest?

Interest earned from the initial principal plus accumulated interest is known as compound interest

What Exactly Is Compound Interest?

Main Points: Compound interest allows you to earn interest on interest

Currently possess

  • In many banks, interest builds up daily, enabling you.
  • for quicker financial growth.
  • Calculating compound interest is simple thanks to online calculators.
  • To maximize your gains, start saving early.

Compound Interest: Definition and Examples

Interest is earned on the original principal plus accrued interest. In addition to receiving interest on your initial deposit, you also receive interest on the interest.

Similar to how the “snowball effect” works, consider how compound interest works. A snowball starts out small, but as more snow is added, it grows larger. It expands faster as it grows, getting bigger.

Exactly how does compound interest operate?

Simple interest is the foundational idea for understanding compound interest. When you deposit money, the bank will pay you interest.

For instance, a $100 deposit would increase to $5 after a year if you received 5% annual interest. Compounding comes into play here, what happens the next year. Your initial deposit and the interest you just earned are both subject to interest payments.

Given that your account balance is now $105, as opposed to $100, the interest your money earns in the second year will be higher.


Your earnings will increase thanks to compound interest even if you don’t make any further deposits.

  • Year One: A $100 initial deposit earns 5% interest, or $5, bringing your balance to $105.
  • Year Two: Your $105 earns $5.25 in interest, or 5%. It currently stands at $110.25.
  • Year Three: A total of $5.51 (5%) is added to your balance of $110.25. Your account balance increases to $115.76.
    This is an illustration of interest that is compounded annually. The process moves even more quickly at many banks, including online banks, where interest compounds daily and is added to your account every month.

Of course, compounding works against you and in favor of your lender if you are borrowing money. On the money you borrowed, you must pay interest. If you haven’t paid the full amount due by the end of the following month, interest will be charged on both the principal borrowed and any accumulated interest.

Formula for compound interest

Compound interest can be calculated in a few different ways. You can gain useful knowledge about how to achieve your savings goals while maintaining reasonable expectations by learning how to do it yourself. Every time you do the math, look at a few “what-if” scenarios with various numbers to see what would happen if you saved a little more or earned interest for an additional few years.

This calculation is simple thanks to tools like our compound interest calculator, which does the math for you and enables you to compare borrowing costs and investment returns in a flash.

Some people favor performing the calculations themselves in order to examine the numbers in greater detail. A regular calculator with an exponents key or a financial calculator with formula storage capabilities are both options.

The compound interest calculation formula is as follows:.

A = P (1+[r/n]) ^ nt

Plug in the following variables to use this calculation:.

Amount you’ll ultimately have.
The principal, which is your initial deposit, is P.
r is the annual interest rate, expressed as a decimal.
n is the annual number of compounding periods (e.g., weekly is 52 and monthly is 12).
t: the period of time (measured in years) over which your money grows.

Performing math

You have $1,000 earning 5% compounded monthly. When 15 years have passed, how much will you have?

A is equal to P (1 + [r / n]) nt.
A = 1000 (1 + [. 05 / 12]) ^ (12 * 15).
A equals 1000 (1 point 004166). ) ^ (180).
A equals 1000 (2.113.703).
A is 2113.70.
After 15 years, you’d have roughly $2,114. Because of rounding, your precise number might differ slightly. Your initial deposit is $1,000, and the remaining $1,114 is interest.

A sample spreadsheet on Google Docs shows how it works. A copy that can be downloaded is also available for use with custom data.

Using Spreadsheets

The entire calculation can be completed by spreadsheets. You’ll usually use a future value calculation to determine your final balance after compounding.

Using the example above, you can do the calculation with Excel’s future value function:. Microsoft Excel, Google Sheets, and other software products offer this function, but you’ll need to adjust the numbers a bit.


Fill out distinct cells for each of your variables. For instance, Cell A1 might have “1000” to signify your initial deposit, and Cell B1 might have “15” to signify 15 years.

The secret to using a spreadsheet for compound interest is to think in terms of compounding periods rather than just years. The periodic interest rate for monthly compounding is equal to the annual rate divided by 12, as there are 12 months or “periods” in a year. The majority of businesses employ 360 or 365 for daily compounding.

=FV([. 05/12],[15*12],1000,).
This example omits the pmt section, which would be a recurring addition to the account. This would be helpful if you were making monthly deposits. Additionally, type is not employed in this situation. If you needed to make a calculation based on when payments are due, you would use this. 1.

The 72-hour rule

Another method for quickly estimating compound interest is the Rule of 72. By considering the interest rate and the time it will take you to earn that rate, this method can help you determine a rough timeframe for when your money will double. Add the interest rate to the number of years. A number of factors will cause your money to roughly double if you get 72. 2.

Example 1: You have $1,000 in savings earning 5% annual percentage yield, or APY. How much time will it take for you to receive $2,000 in your account?
Determine how to reach 72 to learn the solution. It will take approximately 14.4 years to double your money because 72 divided by 5 is equal to 14.4.

Example 2: In 20 years, you’ll require $2,000 and have $1,000 right now. What minimum rate of income must you reach by then to double your money?
Once more, use the data you have—in this case, the number of years—to calculate how long it will take you to reach 72. Since 72 divided by 20 equals 3.6, you must earn about 3.6 percent APY during that time period to reach your goal.

What It Means for Private Savers and Investors

You can ensure that compounding works in your favor as an individual saver and possibly even investor by taking certain steps.

Spend less and save more

Time is your friend when it comes to growing your savings. Compound interest causes money to grow exponentially over time, so the longer you can let your money sit untouched, the more it will grow.

You will have saved $6,000 in deposits and earned $800.61 in interest if you make a $100 monthly deposit at a compound interest rate of 5% over a five-year period. Even if you never make another deposit after that, compounding would have allowed your account to earn an additional $7,573.87 in interest after 20 years, far outpacing your initial $6,000 in deposits.

Look at the APY

Examine the annual percentage yield when comparing bank products like savings accounts and certificates of deposit. It provides a true annual rate by accounting for compounding. Since the APY is greater than the interest rate, banks frequently promote it. Try to get good rates on your savings, but switching banks probably isn’t worth it unless you have a sizable balance.

Pay off debts promptly, and when you can, pay more

You will pay a high price if you only pay the minimum on your credit cards. You won’t even scratch the surface of the interest charges, and your balance might even increase. Avoid capitalizing interest charges (adding unpaid interest charges to the balance total) if you have student loans, or at the very least, pay the interest as it accumulates to avoid a nasty surprise after you graduate. If you can keep your lifetime interest costs to a minimum, you’ll benefit yourself even if you’re not required to pay.

Keep Interest Rates Low

In addition to affecting your monthly payment, the interest rates on your loans determine how quickly your debt will accrue and how long it will take to pay it off. Double-digit interest rates, which the majority of credit cards have, are challenging to deal with. Check to see if it makes sense to consolidate debts and lower interest rates while paying off debt; it could expedite the process and cost you less money.

What Gives Compound Interest Its Power?

When interest is repeatedly paid, compounding takes place. The power of compound interest starts to increase after you keep adding interest after the initial one or two cycles, which are not particularly impressive.


Compounding cycles are important. Daily compounding, for example, produces more dramatic results. Look for accounts that compound daily when opening a savings account. Though calculations can still be done every day, interest payments may only be added to your account once a month. Some accounts only compute interest on a monthly or yearly basis.


Over prolonged periods, compounding becomes more dramatic. Once more, when money is allowed to grow unchecked, you have a higher number of calculations or “credits” to the account.

The interest rate

Your account balance over time will depend on the interest rate as well. Although an account will grow faster at higher rates, a lower rate can still be outperformed by compound interest. An account compounding at a lower rate might have a higher balance at the end of a long period of time than an account using a straightforward calculation. Calculate the break-even point and determine whether that will occur.


Your account balance can also be impacted by deposits and withdrawals. The best strategy is to let your money grow or consistently make new deposits into your account. The effect of compounding is weakened if you withdraw your earnings.

Starting Sum

Compounding is unaffected by the initial sum of money. Compounding operates the same whether you begin with $100 or $1 million. The results appear larger when you start with a large deposit, but you are not penalized for starting small or maintaining separate accounts. When making financial plans, it is best to concentrate on percentages and duration: What rate will you earn, and for how long? The dollars are simply a byproduct of your rate and duration.

Learn more about the topic by clicking here



Deixe seu comentário

O seu endereço de e-mail não será publicado. Campos obrigatórios são marcados com *

*Os comentários não representam a opinião do portal ou de seu editores! Ao publicar você está concordando com a Política de Privacidade.

Sem comentários