Compound interest: What it is and how it impacts your finances
Feb 2, 2023
5 min read
What we'll cover
What compound interest is
How to calculate compound interest
Examples of compound interest from your everyday life
Whatever your profession, you’ve probably heard the old business adage: You have to spend money to make money. We’d like to propose a finance edit for our fiscally-minded friends: You have to save money to make money.
Sound too good to be true? Let us introduce you to compound interest.
The easiest way to think of compound interest is this: It’s interest you earn on your initial principal and your accumulated interest.
Say you deposit a set amount of money in a savings account or a CD. Your initial deposit earns interest, then each time the interest compounds, you earn interest on the principal and on the interest you’ve already accrued. Yes, that’s right. You make money from your money.
Interest can be compounded daily, monthly, quarterly or annually, depending on where you keep your savings. The more often interest compounds, the faster your money grows.
How to calculate compound interest
For the math lovers, you’ll be glad to know there is a specific compound interest formula you can use to calculate compound interest on savings. (Feel free to set the graphic below as your new desktop.)
If that seems too complicated, don’t panic. You can always plug the numbers into a compound interest calculator like this one. With a calculator, you’ll easily be able to see how interest compounded daily compares with interest compounded annually or monthly.
The other great thing about using a calculator is you can run different scenarios to see how much interest you can earn, based on different compounding frequencies, interest rates and deposit amounts.
How compound interest impacts your savings
Compound interest helps you grow your money and it can make a huge difference, whether you’re saving large or small amounts.
Let’s look at the following example of a $1,000 initial deposit (amounts rounded to the nearest dollar):
In this example the amounts are small, but you get the idea. With larger deposits over a longer period of time, the compounding effect can really add up.
Examples of compound interest
What does all of this actually look like in your everyday finances? Compound interest is at work in various places that are probably a part of your financial lifestyle.
It’s likely the place you most often encounter compound interest is your savings account. Depending on your bank and the specific kind of account you have, your interest may be compounding daily, weekly, monthly or even annually. If you’re not sure, ask your bank.
At Ally Bank, we compound interest daily, which can give your savings an advantage over deposit accounts that compound interest just quarterly or annually. That means, in time, you really might just have a dime for every dime you have.
Any money you’ve put in a 401(k) account is benefiting from compound interest. How often it compounds depends on the types of investments in your portfolio.
Unlike the previous examples, where interest increases your investment and savings, interest on your student loan may mean you pay more over time. All federal and most private student loans apply simple interest (more on this type of interest below) to the money you own, which is often applied daily. However, some private lenders may use compound interest on your debt. If you’re not sure, review your lending agreement or reach out to your lender. An important part of paying off that debt is understanding how interest will affect what you owe.
Finally, another common use of compound interest is for credit card debt. Most issuers compound interest charges daily. It’s a good reminder to stay on top of your credit card payments and to avoid making charges beyond what you can afford.
Simple interest vs. compound interest
If you’re a finance nerd (like us) you might be thinking: So, compound interest isn’t the same as simple interest? Correct.
Simple interest is a set percentage of interest you earn on a deposit account each year. Unlike compound interest, which is essentially the interest on your interest, simple interest is only calculated on the original principal of a loan or on the amount deposited into a deposit account.
What determines compound interest?
Interest rate is a major factor in calculating compound interest, but it doesn’t tell the full story. When you’re shopping around for a savings account or a CD, for instance, you should compare APYs. The APY, or annual percentage yield, gives you a better idea of your potential earnings because it takes the frequency of compounding into consideration.
Compound your future
Now that you know everything you need to know about compound interest, go forth with confidence in your financial future. This is just the beginning of a beautiful relationship with another tool to help you take control of your money and help it work for you.