Compound Interest
Compound interest is interest added to the principal of a deposit or loan so that the added interest also earns interest from then on. This addition of interest to the principal is called compounding. Just like simple interest, compound interest pays you a "fee" on the money in your account. But unlike simple interest, compound interest pays you interest on your interest as well!
How it Works
Let's say you have $2,000 in a savings account with an interest rate of 2% for a year. With simple interest you'll make $40 after one year, which means that you'll have $2,040 at the end of the year. But with compound interest, this same $2,000 can earn you more based on the number of times your account "compounds". This could be annually , biannually, monthly, weekly, and even daily. When your account compounds, your interest is calculated and then added back into your account. This means that the next time your account compounds, there will be more money in there than before, which means you'll earn even more interest than the last time.
How it Works
Let's say you have $2,000 in a savings account with an interest rate of 2% for a year. With simple interest you'll make $40 after one year, which means that you'll have $2,040 at the end of the year. But with compound interest, this same $2,000 can earn you more based on the number of times your account "compounds". This could be annually , biannually, monthly, weekly, and even daily. When your account compounds, your interest is calculated and then added back into your account. This means that the next time your account compounds, there will be more money in there than before, which means you'll earn even more interest than the last time.
Compounding Frequency
Not all savings accounts are created equally. This all depends on how often the account compounds. The following chart will help you better understand this:
Time Period |
What Happens |
Annual |
This is the same as simple interest. Therefore, an account with no interest will earn no additional money at all. |
Semi-Annual |
Assuming you deposited $1,000 at an interest rate of 2%, the account would have a total of $1020.10 by the end of the year! |
Monthly |
Compounding monthly would lead to additional money every month. A deposit of $1,000 at 2% interest would grow in no time. |
Daily |
This brings little change daily. It doesn’t look like much, but the few extra cents add up. Most savings accounts are compounded daily. |
Rule of 72
The Rule of 72 is very useful in estimating when the money you put into the bank is expected to double! It's easy too. All that needs to be done is outlined below:
- Step One - Determine and identify your interest rate. For the purpose of example, ours is 8%
- Step Two - Divide 72 by your interest rate. In this case, we'll take 72 and divide it by 8% or just "8".
- Step Three - Find your answer: Dividing 72 by 8 leaves you with 9, which is your final answer.But what does that mean? It means it'll take about 9 years for your money to double. Keep in mind this is just a rough estimate. A true formula for compounding interest would likely give us a number close to 9. This means that if we deposited $100, in 9 years it would become $200. The best part is, you can always deposit additional money to make the process go faster.