Compound interest makes your money work hard for you. But how exactly does the process work? When you earn interest on your money, the money you earned continues the cycle and generates additional earnings. But the concept is hard to grasp by just reading — a visual example can help illustrate the power of compound interest.
Perhaps the most important thing to know is that time works for you when using compound interest. By starting the snowball effect sooner rather than later, your results are better. The ultimate outcome depends on how much you save, how much you earn and how many earnings cycles you experience, but nothing happens until you start.
Earn Interest on Your Savings
When you earn interest, your initial deposit grows by a small amount. For example, if you deposit $100 in an account that pays 2% APY, at the end of one year, you should have $102. Clearly, the results are more dramatic with larger dollar amounts, but start with whatever you have (and the number 100 is often easy for examples).
Here, you can see that the initial deposit earns interest, generating the two smaller pieces. That’s easy enough to understand if you know about simple interest. But the next few steps demonstrate the power of compounding.
Earn Interest on Your Interest
Every time your bank pays interest (whether that’s annually, monthly, or daily), you earn interest on your entire account balance. That includes your original deposit as well as any interest earnings that your bank previously added to your account.
To illustrate the concept, you see how the original deposit earns interest (going up, this time), and the interest earnings also generate their own interest additions. The process is starting to gain momentum at this point, and you can see compound interest in action.
To recap, assuming we’re in the second year and you still earn 2% APY on your savings:
- Your initial $100 deposit earns $2 (again)
- The $2 of interest you earned last year generate $0.04
- Your end of year balance after two years is $104.04
Earn Even More Interest on Your Interest
The process continues as long as you continue to keep your earnings in the account and you continue to earn interest on your funds. If, on the other hand, you remove funds from your account (taking the interest and spending it, for example), the results are less dramatic. For the full effect, you need to leave your account untouched, and the longer you wait to spend, the more you can potentially earn.
The Magic of Compounding
Compound interest is not magic (even if it may seem like it). It’s basic math. And in practice, it’s just discipline and patience. The sooner you start, the better it works.
Comparing rates: When comparing bank accounts, you may come across two types of interest rates.
- An “annual interest rate” tells you how much you earn on your balance over one year. That’s helpful when bank products only pay interest once per year.
- Annual percentage yield (APY) tells you how much you earn over one year, but it’s typically higher than an interest rate. If your account pays interest more often than yearly (many accounts calculate your interest earnings daily), you can potentially earn more, resulting in a higher APY. Whenever possible, compare rates using APY because it takes compounding into account.
So, now that you understand the concept, apply it to your finances.
- Start by running some numbers to calculate specifically how much you can earn with compound interest. You can use online calculators or get the formula and calculate by hand.
- See how to earn the best rates on savings accounts and similar vehicles.
- Learn how different types of CDs allow you to potentially earn more (although you may have to lock up your money).
- Find out if using more than one savings account can help you leave your money alone so it grows undisturbed.
- Understand what you “pay” to use a savings account, even if you never pay a fee.
- Open a high-yield savings account so you have a safe place to keep your money while it grows.