What is Compound Interest?

When you deposit your money into a savings account, the bank pays you for the privilege of holding on to your money. The bank will pay you interest as a percentage of the initial sum you deposit (called the principal amount). The exact amount of interest received depends on the amount of principal, and the interest rate that the bank is willing to pay. For example, if you start with $1000 and the interest rate is 3%, every year you will earn $30 ($1000 x 3%). Therefore after 12 months, your $1000 would rise to $1,030.

Note that 3% is a little higher interest than you’ll be able to get from a bank account in 2013, but the numbers work nicely as an example. It’s possible to earn higher returns with bonds, dividend-paying stocks, and other higher risk investments.

But the bank doesn’t just give you one single interest payment every year. Typically, they pay interest once a month, by dividing the annual interest rate by 12. So rather than getting 3% per year, you get 0.25% every month. On our $1000 principal, that’s $2.50.

What’s the difference? It all works out the same, right? Maybe you get some of the money a little earlier, but in the end, $2.50 times 12 is still $30. Well, not exactly — there’s one important factor we’re not considering: compound interest.

Instead of just paying you interest on your initial $1000 deposit, you’ll also get interest on the interest you’ve already earned on your principal! How does this work in our example? After the first month, you’ll have $1002.50. That’s not much more than what you started with, but the second month, you’ll earn interest on $1002.50 instead of $1000.

At first, the difference is hardly enough to notice — less than a penny the second month, and after the first year, that $1000 is worth $1030.42. Forty-two cents’ difference hardly seems worth remarking. But compound interest is like a snowball, slowly picking up speed. Over time, and as you contribute more to your savings, and especially at higher rates of return, its power is phenomenal.

To illustrate the point, let’s look at the long term: saving for retirement over 40 years. If you were to receive just 3% of your $1000 principal every year (simple interest as opposed to compound interest), you would earn $1200 for a total of $2200. But through compounding alone — earning interest on interest — you’d earn nearly twice as much: $2315, for a total of $3315.

Savings Calculator: 40 years at 3 percent

You can see this for yourself by playing with Money Hacker’s savings calculator. Take a look at what happens when you adjust the interest rate, or deposit a small additional contribution every month!

2 Responses to “What is Compound Interest?”

  1. Nadine says:

    Great article and I love the Money Hacker’s saving calculator. I love playing with it and just imagining how much money I could make by just saving a little bit every month.

  2. val yenko says:

    That savings calculator is really helpful. Many of us don’t realize the power of a savings account and with interest compounding, it really does add up to some serious change. Your example is only $1000, imagine that being $25000 or even $50000. The end result is well worth the effort.

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