Whenever you hear a person tell you that you should “make your money work for you, and not work for your money,” they’re often referring to compound interest. On a simple interest investment, you earn interest only on the original principal you’ve invested. A compound interest investment will pay you interest on the original principal AND interest on the interest you’ve already earned.
Because you’re basically earning interest on your interest, longevity matters. To truly enjoy exponential returns from compound interest, you need to really be committed to a long-term investment strategy.
Compound Interest versus Simple Interest
If you purchased a $10,000, 30-year bond (a simple-interest investment) earning a generous 8% interest rate, then your investment would earn a steady $800 per year. At the end of 30 years, when the bond matures, it will be worth $34,000
If that same $10,000 earned 8% interest compounded annually, then the first year, it would pay $800. The new balance would be $10,800, so 8% the second year would now get you $864, so by the end of the second year, your investment is already outpacing your simple-interest bond. By the end of the 30-year period, the annually-compounded investment would be worth over $100,000.
So, which would you rather have? $34,000 or $100,000? Both required the same initial investment capital, invested over the same period of time.
A compounding period essentially describes how often interest is compounded, usually over a 12-month period. The number of times interest is compounded makes a huge difference in the amount of interest earned. For example, an interest rate of just 5% compounded quarterly will earn more than one with an interest rate of 10% compounded annually.
When seeking investments that take advantage of compound interest, you should be looking at more than just the potential yield. For example, if the investment compounds interest monthly or quarterly, there may be some wiggle room for you to take a hit on the interest rate.
How Is Compound Interest Calculated?
The calculation for compound interest can seem complex on the surface, especially for those who don’t have a postgraduate degree in mathematics or economics. However, for those who don’t care about the semantics behind compound interest, you can use this free compound interest calculator to toy around with it.
Here’s the official formula that’s used to calculate compound interest:
= [P (1 + i)n] – P
= P [(1 + i)n – 1]
P=principal, i=annual interest rate (percentage)
n=number of compounding periods
Here’s an example using the formula above. Assume this is for a starting principal of $10,000, earning 6% interest over 5 years.
[(1 + 0.06)5 – 1] = $10,000 [1.338226 – 1] = $3,382.26.
So after 5 years of 6% growth that gets compounded annually, your $10,000 is now $13,382.26
Calculating Compound Interest With Excel
The above example was made to be simple so that anyone reading this can understand it. However, there are times when calculating compound interest gets a little tricky. Especially due to the exponential growth that longevity can bring for compound interest investments.
Of course, there’s nothing that Microsoft Excel can’t handle!
Now you can set up labels however you’d like with investment amount, years, interest rate, etc., but here’s the easiest way to calculate it. Enter your initial investment amount into a cell. For this example, we’ll assume it’s cell A1 and your principal is $1,000.
Next, you need your interest rate. Let’s use an interest rate of 8% for this example. Because we want to use the original principal amount multiplied by the interest rate, our formula will include 1.08 (1 for the original amount and .08 for the interest). Your formula for cell A2 should be =A1*1.08. This is $1,000 * 1.08 is $1,080.
Your new total of $1,080 will be compounded again, so the A3 formula should be =A2*1.08, which now gives you $1,166.40. Each cell (A2, A3, etc.) represents the compounding period. If your investment was for annual compounding, A3 would represent year 3. If it was quarterly compounding, A3 would represent the third quarter.
There is no compound interest feature, but you can use a formula in excel to create your own compound interest calculator (and it’s not hard at all, copy and paste our formula!):
- Create Your Labels
- A2 = Investment Principal
- A3 = Interest Rate
- A4 = # Of Compounding Periods Per Year
- A5 = Number of Years
- A7 = Total Amount Earned
- Enter Your Formula For Cell B7
- Enter Your Values Into Cells A2-A5
The Magical “Power of 72”
There is a simple way that you can calculate how often your money will double by using the “Power of 72.” At a given interest rate, your money should double over a certain period of time if you’re taking advantage of compound interest.
Simply divide 72 by your interest rate. For example, any amount invested which earns 8% interest that is compounded annually should double every 9 years. In this example, with your money doubling every 9 years, you can see how advantageous it is to let your principal accrue as much compounding interest as possible.
Why Time Matters For Compound Interest
We’ve said it over and over again, and we’ll say it until we’re blue in the face: time is the most important factor for compound interest investments. So let’s take a look at two hypothetical situations. (A conservative average of the S&P Index is about 10%, so we’ll use 10% interest in these examples).
Example 1: The family of a newborn puts $10,000 into a fund earning 10% interest that is compounded annually. Assuming the money is not touched until the child grows well into adulthood and hits the retirement age of 62, that $10,00 investment is now worth $3,684,227.84 without ever making a single contribution to this fund throughout the child’s lifetime.
Example 2: A guy fresh in his 30’s decides to start a retirement fund for himself. He moves $25,000 from his savings into a retirement fund, earning that same 10% interest rate. In addition to this $25,000, he also puts away an extra $2,500 per year into this fund and does so until he is also of retirement age, 62. Now even though he started with a much bigger initial principal amount AND he contributes thousands of dollars every single year for over 30 years, his final total sits at $1,030,680.79
Now, all of us would be happy to have a million bucks waiting for us. However, we would also all much rather have well over $3 million waiting for us with a fraction of the effort involved, aside from making sure time worked in our favor. The above examples are a great way to see that the earlier you start compounding, the better your results will be.
Can Compound Interest Hurt You?
So far, everything we’ve said about compound interest has used examples of investments. Compounded interest on an investment will never hurt you. You should ALWAYS seek out investments where the interest is compounded.
Compound interest can hurt you if you owe money to someone else. For example, a common debt that compounds interest is credit card debt, and this interest is almost always compounded monthly. By having the interest compounded every month, you will pay the credit card companies a lot more than you would on a simple-interest loan, like a car loan.
How Can Compound Interest Help You?
In addition to the investments we’ve talked about already, there are other ways that you can make compound interest work in your favor.
A long-term loan, such as a home mortgage, uses compound interest to determine how much of your payment goes towards the principal and how much the bank profits off of interest. For example, if you pay half of your mortgage payment twice a month, you will eat into your amortization. This will save you a substantial amount on interest payments over the course of your loan.
Note: Check with your lender before doing this to ensure they don’t have fees for multiple payments per month and don’t have any prepayment penalties.
Types of Compound Interest Investments
Most investments allow you to earn “interest on your interest” or compound interest. A common exception would be bonds and treasury bonds, as those only pay a fixed interest rate on your original principal.
Some common investments you might already have are earning compound interest:
- Stock Portfolios
- Retirement Funds
- Certificates of Deposit (CDs)
- High-Yield Savings Accounts
- Interest-Bearing Checking Accounts
How To Tell if Interest Is Being Compounded
For Borrowed Money: The Treasury Department makes sure all lenders follow the Truth in Lending Act. This requires lenders to disclose whether or not borrowing money from them will have payments whose interest is compounded. You can also check to see if the interest rate and the APR are two different numbers.
For Investments: If you’re going to earn money on the interest you’ve already earned, it’s compound interest. A simple-interest investment is a rarity these days (again, except for most bonds), so it’s not something most people need to worry about. But, of course, you can always verify with the institution or brokerage issuing the investment that you are getting compound interest.