Any time you look for financial advice, one of the biggest elements is saving. Saving for a rainy day. Saving for a major purchase. Above all, saving for retirement. If you’re struggling to keep your finances in the black now, the idea of meeting all these savings goals might seem completely unattainable. That’s where compound interest comes in. Instead of having to earn every penny yourself, you can sock away a little bit of money and have it multiply.
What Is Compound Interest?
Compound interest, in its most basic form, means that you earn interest on your interest. Say you deposit $100 in a bank account that earns 1% interest annually. At the end of the first year, you have $101. At the end of the second year, instead of having $102, you’ll have $102.01. In this example the difference is tiny, but over time that tiny difference can grow.
This is an example of the time value of money. Having $100 now might not seem like much, but it’s better than having $100 twenty years from now when you retire because you can use the intervening time to make that money grow.
How fast your balance grows will depend on a few different factors, primarily the interest rate and the compounding period. All other things being equal, a higher interest rate will get you more money. Meanwhile, interest that compounds daily will grow more quickly than interest that compounds monthly or yearly. Make sure to consider both of these elements when shopping around for accounts.
Compound Interest and Debt
Compound interest is a great deal if it’s your money that’s growing. The opposite is true when your debts are growing!
You need to consider the effects of compound interest on all your debts. However, credit cards can be particularly harmful in this regard. Many have interest rates as high as 25% and compound daily, so your balance can grow very quickly if you don’t pay it off every month.
How Is Compound Interest Calculated?
Interest is generally expressed as an annual amount even when it compounds more frequently. For example, if you have an account with 6% interest that compounds monthly, you don’t get 6% every month. You get 0.5% every month. This still gives you a slight advantage over someone who is earning 6% all at once at the end of the year.
But how do you calculate compound interest in the real world when the numbers aren’t chosen to make the math easy? You could use any one of the many compound interest calculators available on the web. If you want to double-check these numbers or just really like doing the math yourself, the formula for compound interest is A=P(1+r/n)nt, where:
A = ending amount
P = original balance
r = interest rate, expressed as a decimal
n = number of times interest is compounded in a specific time frame
t = time frame
For example, if you put $100 in an account with interest of 6% per year compounded monthly and you wanted to know how much you’d have after 5 years, your equation would be A = 100(1+0.06/12)12×5.
When you’re looking into compounding intervals, you might come across a concept called continuous compounding. This requires using logarithms and exponents to calculate but can be useful in making certain types of comparisons between accounts.
In practice, your interest will not compound continuously because at the very least there’s a certain amount of time required to make a calculation. Furthermore, your bank probably won’t want to invest the processing power required to make calculations in the smallest fraction of time possible. If a bank does advertise continuous compounding, make sure to read the fine print and determine whether it’s actually continuous or just very, very frequent.
The Rule of 72
On the less complicated end of things, the rule of 72 can be used for a quick on-the-fly estimate of how long it will take to double your money. In this formula, 72 = the interest rate x the number of years it will take for your money to double. So if you know your account makes a 6% interest rate, you can divide 72 by 6 to discover that it will take 12 years to double your money. Alternatively, if you know you want to double your money in 10 years, you can divide 72 by 10 to find that you would need to earn a 7.2% interest rate.
Learn How to Grow Your Investments
Finding enough money to save for all your goals can be an intimidating prospect. Compound interest helps grow your money without any additional work on your part, but it can be difficult to compare various rates and compounding periods to find out what’s best for you. Contact us to connect with an experienced advisor who can walk you through the process!