If you have a savings account, you know what interest is. It’s that little bit of extra cash that the bank pays you for letting them hold your money (and these days, unfortunately, it’s usually a tiny bit).
You also know what interest is if you have a credit card balance or a loan. In that case, it’s the fee you pay for borrowing money.
But interest is often supercharged—it’s more than just a percentage of your original balance. That’s called compound interest.
Compound interest is good news if you’re saving money—it could help your balance grow faster. But, it’s not-so-good news if you’re in debt—it could boost what you owe.
That’s why it’s vital to understand compound interest before deciding where and how to save or borrow money. You should pay attention to how often interest is compounded. And you should avoid letting your credit card balances grow.
Simple vs. Compound
To understand how compound interest works, let’s look at another kind of interest: Simple interest.
Let’s say you invest $1,000 at 5% annual interest, and then you don’t touch that money. At the end of 10 years, you’ll have $1,500—your original investment plus $50 in interest each year for 10 years. After 20 years, you’ll have $2,000. After 30 years, you’ll have $2,500. That’s simple interest. The interest is figured only on your original balance, even as you earn interest each year.
Now, let’s say you invest the same $1,000 at 5% per year in an account that compounds interest annually. After 10 years, you’ll have $1,629. After 20 years: $2,653. After 30 years: $4,322.
That’s what financial professionals sometimes refer to as the “magic of compound interest.” By year 30, you’d be $1,822 richer than if you had invested in a simple-interest account.
Why? Because compound interest means you’re earning interest on interest. Every time you earn interest, it’s added to your investment balance, and future interest is based on that ever-growing amount.
Now let’s say that your interest is compounded monthly instead of annually. Instead of $4,322, you’ll have $4,468 after 30 years. And if your interest is compounded daily, you’ll have $4,481.
The more your interest is added to your balance, the faster your money grows.
These days, most bank savings accounts offer compound interest. Yes, their interest rates generally are stunningly low—averaging just 0.07% for a $2,500 deposit as of May 16, 2022—but your money will grow faster with interest compounded frequently.
You’ll do somewhat better with a certificate of deposit, depending on how long the term is and how much you invest.
Before choosing which account to open, check the details. Find out what the compounding frequency is—how often is interest compounded? The more frequent, the better. Also, banks may offer different interest rates based on how much you invest. Find out if a minimum investment is required.
You can compare compound-interest-paying accounts by checking each account’s annual percentage yield (or APY), which factors in compounding.
Don’t Get Unbalanced
Unfortunately, when you use a credit card or take out certain loans, compound interest works the other way, too, making your debt more expensive.
Credit card interest rates tend to be pretty steep to begin with. The annual rate averaged about 16.2% as of February 2022, according to the Federal Reserve. But on top of that, interest typically is compounded daily based on your average daily balance for a given monthly billing cycle. That interest is constantly being added back into your card balance.
The good news is that you won’t pay any interest charges if you pay off your credit card balance when your statement arrives each month. But if you can’t get your balance to zero, pay as much as possible early in your billing cycle. That will reduce your card’s average daily balance for the month, lowering your interest tab. (Many credit card companies let you pay online before the bill arrives, even multiple times a month.)
The Power of Paying Down Principal
Most home mortgages and car loans are simple-interest forms of debt, but they seem like compound interest because of the way they are structured. Early in the loan, most of your monthly payment goes toward interest, and less goes to paying off your loan principal.
That repayment structure—known as an amortization schedule—costs you more in interest than if you paid off the principal first, especially on a 30-year mortgage. That’s because your balance stays high for years. So, consider making extra payments toward your mortgage principal. That way, you could pay off your loan sooner and save thousands of dollars in interest.
However, you should check with your lender about any prepayment fees attached to your mortgage. Also, make sure your extra payments go only toward principal, not interest.
Whether you’re looking at compound interest for your savings or debt, knowing what it means is the first step!