What is Compound Interest?

Accounts pay two main types of interest. Simple interest pays a set percentage of the principal, such as 6%. Then there’s compound interest, which helps you grow your savings more quickly. You earn interest on your original principal, and you also earn interest on that interest.

Both banks and credit unions offer compound interest accounts, but they go by different names. At a bank, you earn “compound interest.” At a credit union, you may hear terms like “compound dividends” or “dividend rate.” As a credit union customer, you are part-owner of the credit union. That makes you an investor entitled to dividends, which are a portion of the credit union’s profits.

How does compound interest work?

Compound interest (or compound dividends at a credit union) can lead to growth that snowballs. You earn interest on your principal, and that interest gets added to your principal. Then you start earning interest on the entire amount – the principal and the accumulated interest.

Factors that determine how quickly your money grows are:

• your principal. This is the money you initially deposited or invested.
• the dividend or interest rate, which is the return you receive for depositing or investing money. An interest rate is expressed as a percentage of the principal amount, such as 5%. Your annual percentage yield (APY) takes into account compounding interest, so it’s an accurate assessment of how much you’ll earn over a year.
• how often the interest is calculated. Depending on the account, your interest may compound daily, weekly, monthly, quarterly, or annually. The more compounding periods you have, the greater the growth.
• additional contributions, such as deposits that you make to the account weekly, monthly, or otherwise.

Simple interest vs. compound interest

Simple interest is interest calculated only on the principal amount. If you deposit $1,000 into an account that compounds annually and earn 6%, you’ll earn $60 every year – no more. Each year, your interest is always calculated on that same principal amount. Your money grows steadily, but slowly, over time.

If you have an account that earns compound interest, something different happens. You earn interest on the principal and you earn interest on interest that has been credited in the past. So, if you deposited $1,000 with 6% interest, you’d earn $60 the first year, the same as with a simple interest account. But the second year, you’d earn interest on the new total – $1,060 – not just your original deposit of $1,000. Growth may begin slowly, but the longer you have your account, the faster it grows.

What is the formula for compound interest?

You can calculate how much your compound interest account will grow using this formula:

FV = P x (1 + r)^nt

• FV represents the “future value” of your account at a specific date in the future, including the interest earned.
• P is your account’s present value.
• 1 represents your original principal (100% of your original money)
• r is the account’s annual interest rate, which gets converted into a decimal. So if your interest rate is 7%, it would be represented in the formula as 0.07.
• n is the number of times you’re compounding in a year. If your account is compounded monthly, for example, n would be 12, since there are 12 months in a year. If the account is compounded weekly, n would be 52.
• t is the time, in years, that you’re projecting forward. So if you’d like to learn how much money your account will have in 20 years, t would be 20.

The Rule of 72

Wondering how long it will take for your account’s value to double with compounded interest? Simply use the Rule of 72. Divide 72 by the account’s interest rate to get the number of years. If the interest rate is 7%, for example, you’d divide 72 by 7 to get 10.3 ayears. In a little over a decade, then, your money will double.

Example of compound interest

Compound interest takes advantage of the accumulated interest for all the previous periods of your account. You may not notice much growth in the first year or two. But over 10 years, 20 years, or more, you’ll see the power of compound interest.

Let’s say you have a principal of $1,000, with an annual percentage yield (APY) of 3.5%, compounded monthly. Over 20 years, you would earn $1,011.70 in interest and have more than doubled your money to $2,011.70. And that’s if you never added more money to your savings.

But what happens if you make regular deposits to your account? If you open an account with that same $1,000 to start, and then deposit $100 into that account each month, you’ll earn $11,698 in interest over 20 years.

In this scenario, your principal was $1,000, you made $24,000 total in monthly deposits, and you earned $11,698 in interest (which includes interest on your interest) giving you $36,698 after 20 years.

The magic of compounding is accelerated growth, especially when you make regular deposits or contributions to your account.

How to maximize compound interest

You can put money into a high-yield savings account to earn compound interest. But there are other types of accounts that earn compound interest, too, such as share certificates, money market accounts, stocks, bonds, mutual funds, and more.

To really maximize the benefits of compound interest, follow these tips.

• Start early. The earlier you open a compound interest account, the longer your money earns interest or dividends and the more it will grow.
• Make regular contributions. The more money you deposit into the account, the more interest you’ll earn.
• Choose investments with care. If you open an investment account, choose investments with long-term growth potential.
• Reinvest your earnings. Avoid withdrawing interest or dividends. Instead, reinvest them so your money can continue to work for you.