Budgets and Money

What Is Compound Interest?

Compound interest can seem complicated, but simply put it is money that grows from interest on your interest enabling your savings to grow. 

Compounding Interest and Why it Matters

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 is what can allow your money to grow and multiply over time, and it is the reason why so many people put their savings in stocks, bonds, CDs and other 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 you maximize your savings.

When you deposit your money in a savings account, it begins to earn interest. Over the years 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 invest $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.

Compounding interest can be a much better deal. When your interest compounds, then you will also earn interest on the interest that you earn. For example, if you have $1,000 to invest, and you put it in an investment that pays 5% per year compounded, then you will have $1,050 at the end of one year. The next year, you will earn 5% on that $1,050 instead of just $1,000. 5% 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% 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 sums of $10,000. One of these amounts earns simple interest while the other one earns compounding interest. The following numbers show how much more you will earn when the interest compounds. 

Simple Interest
Initial Amount $10,000 TOTAL
Interest Earned at 8% $800 $10,800
$800 $11,600
$800 $12,400
$800 $13,200
$800 $14,000
Compounding Interest
Initial Amount $10,000 TOTAL
Interest Earned at 8% $800 $10,800
$864 $11,664
$933.12 $933.12
$1,007.77 $13,604.89
$1,088.39 $14,693.28

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.

Now, that may not seem like a lot of money, but you need to think of the benefits of compound interest in the long-term. Remember, just as soon as you make a deposit, the magic of compound interest could begin to grow your savings at a steady rate over time. 

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All Learning Center articles are general summaries that can be used when considering your financial future at various life stages. The information presented is for educational purposes and is meant to supplement other information specific to your situation. It is not intended as investment advice and does not necessarily represent the opinion of Protective Life or its subsidiaries.

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Financial Planning Basics

Header: Financial Planning Basics A solid financial plan begins with basics such as saving as much as you can for things such as college and retirement. This article looks at how compound interest can help you build your savings over time. For more information, visit the Protective Life Learning Center.