Understanding the power of compound interest

Learning about the power of compounding now can help you understand how to make the most of your money far into the future.

…

“Compound interest” may be a term you often hear, but do not completely understand. However, understanding how compounding works isn’t hard, and it can help you see how interest adds up, whether you’re signing up for a new car loan or a savings account. Compound interest may make the difference between whether you end up deeply in debt or with a healthy savings. Here’s how:

  • If you’re paying interest on debts like credit cards, student loans, or a car loan, compound growth can cost you more in interest charges over time.
  • If you’re earning interest — on anything from a high-yield savings account to your workplace retirement plan — compound growth can work in your favor. Over time, you can pile up significantly more interest payoffs in your accounts, thanks to the power of compounding.

Debt: When compounding isn’t your friend

When you take out any kind of credit, the lender charges you interest on the amount you borrowed — or your “principal” amount. If you don’t pay off the debt right away, those recurring interest charges are added to your principal like new snow being added to a snowball.

Your loan amount — now a bigger snowball of principal plus interest — can continue to grow larger and larger if you don’t make your monthly payments. That larger debt then incurs even more in interest charges over time. In other words, you start paying interest on your interest, in addition to your original loan amount.

Credit cards are a good example. Say you have a $1,000 balance on a credit card at an interest rate of 16.4%. For simplicity, let’s say you make the minimum payment each month, which is typically a certain percent of your balance — for this example, we’ll say 2.5% (or $25 for that first payment).

By paying just the minimum payment, it will take you 8 years and 7 months to pay off that $1,000 balance. You’ll end up paying $1,756.59 total — $756.59 of which is interest.

Saving and investing: When compounding works for you

Compound interest can work to your benefit, too. Let’s take that same $1,000 and assume you put it into a savings account: This time, instead of paying interest, you’re earning it.

Remember, your balance and the earned interest get compounded. Every year, you have a higher account balance. As such, you also earn more interest on that higher balance. You’re now earning interest on your interest.

Year Additions (for the year) +2% interest earnings (earnings for the year, compounded daily) Ending balance (Your money)
0 $1,000 $0 $1,000
5 $0 $21 $1,105
10 $0 $24 $1,221

As you can see, by leaving your savings in the bank, your balance can grow because of compounding interest. If you make it a habit to deposit more money into this savings account each month, compounding can earn you even more interest. Check out what happens when you start with $1,000, but also add in $500 each month:

Year Additions (for the year) +2% interest earnings (earnings for the year, compounded daily) Ending balance (Your money)
0 $1,000 $0 $1,000
5 $6,000 $725 $32,682
10 $6,000 $1,285 $67,697

How to keep compound growth working for you

In short, time is your key factor. The longer you take to pay down debt, the more interest you’ll compound and have to pay. However, if you have savings and investment accounts, time works in your favor. The longer you keep money in your account, the more time you have for the interest to compound and grow for you.

  • If you have debt: Make payments regularly, on time. Try not to get behind on payments, since you’ll be at risk to incur more interest. If you can pay extra toward your loan payments, great! You may pay less interest over the life of your loan.
  • If you have savings: Start putting away money as early as you can. If you start saving for a house or retirement in your 20s, your money can compound and earn significantly more interest than the account of a person who starts saving or investing in their 40s. More time to save and invest gives you more compound interest.

A single strategy that can help you both lower compound interest on your loans and boost interest on your savings is to sign up with your bank for automatic payments and deposits. That way, you won’t forget to make a loan payment or to deposit money in your saving accounts.

Understanding the concept of compounding is just one way to improve your financial health. Learn more by viewing our Financial Health Toolkit.