What Is Compound Interest With an Example?
Compound interest refers to a method of applying interest that is generated from your principal plus its interest. This method of calculating is common on credit cards and other loans where you are paying off a bill. However, it can also work to your advantage when you find its use in your retirement investments.
Albert Einstein reportedly described compound interest as "the most powerful force in the universe." This method is also known as compounding interest, compound return, and compound annual growth rate.
Compound Interest in Investments
Compound interest puts your money to work for you and grows larger as it feeds on itself. You can use the Rule of 72 when you know the regular rate of return you will receive to calculate how long it will take you to double your original principle.
Imagine that you put $100 into a retirement investment account. It earns interest at a rate of 10% per year. At the end of a year, you have $110.
You start year two with $110 in your investment account—$100 from the principal and $10 from the interest. You keep the full $110, Both your principal and the interest, vested throughout the year. By the end of year two, your investment has grown by another $11, for a total of $121.
Notice that in year one, you earned $10 in interest, because the only money that you had was the principal. But in year two, you earned $11 in interest, because you had the principal PLUS the first year's interest. In other words, that extra $1 represents the interest that compounded on top of your interest.
You start year three with $121 in your investment account. You earn 10%, or $12.10. At the end of the year, you have $133.10.
Notice how your 10% payout has grown—from $10 the first year, to $11 the second year, to $12.10 the third year. It is because interest is compounding on top of previous interest.
In the fourth year, your 10% payment will be $13.31 (which is 10 percent of $133.10, which means you'll end the year with $146.41. Notice that at this point, you've earned $46 on your original investment of $100. Not bad.
What if you hadn't reinvested your returns? In year one, you get a 10% return. You keep the principal, the original $100, invested, but you spend the extra $10. At the start of year two, you only have $100 invested.
You do this every year - keeping the original $100 invested, but removing the extra $10. By the end of Year 4, you've made only $40, not $46.41, because you didn't let the interest compound.
Imagine doing this with $10,000. At a 10% compounding interest rate, you'll earn $4,600 on your original investment by the end of the fourth year.
Better yet, imagine doing this with $100,000. At a 10% compounding rate, you'd earn $46,000.
Most investments don't give consistent 10% returns. Investing legend Warren Buffet predicts that the stock market will give 7% returns through the early-to-mid 21st century.
You invest $50 at a 10% interest rate. After one year, you have $5, for a total of $55. In your second year, you earn interest on your original investment of $50 (this is the "principal") plus the additional $5 that you earned in interest during year one.
In other words, you'll earn $55 plus 10%, which equals $5.50, for a total of $60.50.
The "compounding interest" is that extra 50 cents, which is the interest that you earned on your interest.
The longer you let interest compound, the more dramatic your gains will be (because you'll have more interest).