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Interest is one of the costs of borrowing money. When someone takes out a loan, they repay the borrowed amount plus interest. On the flip side, a person may earn interest when putting funds into a savings account or investment.
Accounts generally use either simple interest or compound interest. With simple interest, the interest rate only applies to the principal balance. But with compound interest, the interest rate applies to the principal balance plus accrued interest.
Find out what compound interest is, how it may work, and potential benefits and drawbacks.
Compound interest is when interest accrues on interest. It can make loans more expensive for borrowers, but it can also help savers earn more interest over time.
For example, someone puts $5,000 into a savings account that has a 3% interest rate. If the account uses simple interest, it accrues $150 over the year. The account would then have a $5,150 balance, but the interest accrued over the next year would remain the same. At the end of the second year (assuming no other deposits are made), the account would accrue another $150 in interest, ending with a total balance of $5,300.
But if the interest compounds annually, the account accrues a different amount. It would still accrue $150 of interest the first year. Then, the 3% interest rate applies to the new $5,150 balance, meaning $154.50 accrues at the end of the second year. At the end of the third year, the person earns an additional $159.14 (3% of $5,304.50). In total, they earn $463.64, an additional $13.64 worth of interest on the interest.
Calculating compound interest can be tricky, particularly when the underlying balance continually changes. For example, balances are regularly changing when someone is paying down a loan, depositing or withdrawing money from a savings account, or using a credit card for everyday purchases.
But there are many compound interest calculators that can help borrowers estimate their total costs or savings. A loan offer will show the APR and may also outline the monthly and total interest payments, which allows borrowers to review the terms before accepting.
Banks and other depository institutions advertise the annual percentage rate (APY) on certain accounts, such as savings accounts. The APY considers the interest rate and compounding interest to tell savers how much interest they can expect to earn each year based on their balance.
Interest can compound at different intervals. Common compounding periods include:
The more frequent interest compounds, the more interest accrues.
Compound interest matters because it can affect how much interest someone earns or pays. It can be especially significant when there's a large initial balance, a frequent compounding period, high interest rate, or a long period of time.
For example, credit cards may have relatively high interest rates and the interest often compounds daily. As a result, financing large purchases with a credit card might be more expensive than alternative options with lower rates and less frequent compounding periods.
When considering savings, people who set aside money for an emergency fund or save for a long-term goal may want a frequent compounding period. For example, PayPal Savings compounds interest daily, which may help people build their savings over time with a quicker compounding frequency.
For individuals, the main benefit of compound interest is that it allows them to increase their wealth. Compounding interest may lead to exponential growth, which can result in large changes over time.
For instance, someone who has $10,000 in a retirement account could wind up with over $44,000 after 30 years if they earn a 5% interest rate with monthly compounding periods. They more than quadruple their savings in this scenario, even if they don't contribute any more money.
The main drawback is that compounding works against borrowers and can make paying off debts more difficult. Sometimes, interest can accrue so quickly that the total balance grows each month, even though the person makes their minimum payments.
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