Someone once asked Albert Einstein, the famed physicist of the 20th century what the most powerful force in the universe is. Without missing a beat, he promptly responded, “compound interest.”
This endorsement coming from one of the greatest minds in history is well-deserved. Compound interest can help your money to grow over time, and it is the reason why so many people put their savings in interest-bearing investments that can provide compound rates of return.
A goal of most financial plans is to grow your savings for things like a new home, college, retirement and emergency needs. We would all like to watch our savings grow, right? And while every little increase is a welcomed sight, the bigger the better! This is where compound interest comes in and how it can help maximize your savings.
When you make a deposit in a savings account, it begins earning interest. That interest continues to build, earning more interest on top of what you have already earned. Simply put, compound interest amounts to interest payments on your existing balance and prior interest payments.
How compound interest works
The principle of compounding interest is very simple. But to understand how it works, first we must look at the concept of simple interest.
Simple interest pays you the rate of interest that is promised, but it is only paid on the principal that you invest. For example, if you put $1,000 in an investment that pays simple interest, then you will earn $50 each year from that investment. But that is all you will get.
With compounding interest, you also earn interest on the interest that you earn, not just the principal.
For example, if you have $1,000 to invest, and you put it in an investment that pays 5 percent per year compounded, then you will have $1,050 at the end of one year. The next year, you will earn 5 percent on that $1,050 instead of just $1,000.
Five percent of $1,050 comes to $52.50. You will therefore earn $2.50 more in interest, because you are also earning interest on the $50 of interest that you earned the year before. And the next year, you will earn 5 percent on $1,102.50, which comes to $55.13. This time you earn $5.13 more than you would if your investment was paying simple interest. When banks advertise a given rate of interest for their CDs or savings accounts, it is often a compound rate of interest.
The effects of compound interest are seen most clearly over long periods of time. Here is another illustration that shows the difference between simple and compound interest. We start here with two investments of $10,000. One of these amounts earns simple interest while the other one earns compounding interest. The following chart shows how much more you will earn when the annual interest compounds.
After just five years, you have almost $700 more from compounding than you do with simple interest. This is a very important principle to understand when you invest.
That may not seem like a lot of money, but think of the benefits of compound interest in the long term. Remember, just as soon as you make a deposit to a savings account, the magic of compound interest could begin to grow your savings at a steady rate over time.