Compound interest is undoubtedly the most important concept to understand when building wealth for the long term. If you put your money into an account that earns compound interest, you'll see your wealth grow exponentially. Here's a closer look at how it works.
How it works
How compound interest worksCompounding happens when you put money into an account that earns interest. When the account pays interest, the interest payment stays in the account. As a result, the amount earning interest grows bigger and bigger with each new interest payment.
It's a relatively simple concept, but one with mind-blowing possibilities. The longer you let your investments grow, the more rapidly they grow. Consider a single $1,000 investment growing at 10% annually:
Now, imagine what would happen if you were to start with $5,000 or $10,000 and keep contributing more money to your account regularly and making smart investment choices to increase your returns.
Simple vs. compound
Simple interest vs. compound interest
While compound interest includes interest earned on previously generated interest, simple interest is just the interest rate multiplied by the investment or principal amount.
Simple interest is often used in a loan or bond context where the interest is the same every period, and there is no compounding. Compound interest is used in investment and savings contexts.
The simple interest formula (variables defined in the next section) is A = P(1 + R * T).This means the account value is equal to the original investment amount times 1 plus the rate multiplied by the time. The simple interest formula isn't as complicated as the compound formula below because it doesn't include the compounding factor.
Compound interest formula
Let's go over the compound interest formula and define each variable.
P(1 + R/N)^(N*T) = A
- Principal: P is the investment or principal balance at the start of the investment. If you use a spreadsheet or a financial calculator to calculate interest, principal is also known as present value.
- Rate: R is the interest rate earned on the investment.
- Number: N is the number of times interest is compounded per period. For example, many savings accounts compound monthly but have an annual interest rate.
- Time periods: T is the number of time periods.
- Account value: The formula calculates the account value, A. This variable is also known as future value.
$10,000(1+.01/12)^(12*5) = $10,512.49
Accounts that offer it
Which types of accounts offer compound interest?You have several options for taking advantage of compounding interest to build wealth. Each of these investing strategies generates compound interest:
- Savings accounts: Banks lend out the cash you put into a savings account and pay you interest in exchange for not withdrawing the funds. Savings accounts that compound daily, as opposed to weekly or monthly, are the best because frequently compounding interest increases your account balance faster. You can open a savings account with any local or online bank.
- Money market accounts: These are almost the same as savings accounts, except money market accounts allow you to write checks and make ATM withdrawals. Money market accounts often pay slightly higher interest rates than savings accounts, too. The downsides of money market accounts are that most limit how many transactions you can complete monthly, and some charge a fee if your balance falls below a certain amount.
- Certificate of deposit (CD): A certificate of deposit requires you to lock your money up with a bank for a specified period of time (typically six months to five years). In exchange for keeping your money in the CD, you'll get a guaranteed interest rate on your money. The interest payments accrue in the account, compounding over the life of the CD.
- Dividend stocks: Stocks that pay dividends compound in a similar way to compound interest if you reinvest the dividends. You can instruct your brokerage to automatically reinvest all dividend payments you receive and buy more shares.
Generally speaking, if you stay within Federal Deposit Insurance Corp. (FDIC) limits, savings and money market accounts are both extremely safe options. They've become even more attractive since interest rates rose quickly in 2022 and 2023.However, to profit significantly from compounding interest, it's important to diversify your money with different types of accounts and investments.
In the news
Compound interest in the news
Interest rates on savings accounts, money market funds, and CDs are driven primarily by the federal funds rate. The Federal Reserve has consistently raised rates since the start of 2022. But investors expect the Fed to reverse course in 2024, cutting interest rates as many as four times, which could lead to lower interest rates offered by banks.
Meanwhile, the rate you can get on plain savings accounts has risen drastically over the past couple of years. Some providers offer fully liquid savings accounts that pay between 4% and 5.5%, and perhaps even slightly higher rates if you sign up for a CD. In fact, locking in a longer-term CD rate today could be a good choice for some in the face of impending interest rate cuts.
Over the past decade, keeping money in cash has been seen as a drag on your investment portfolio. The game is different now; holding cash in readily available savings can provide a more-than-acceptable return, especially considering you won't experience the same day-to-day volatility while holding cash as you will with the stock market. A sizable cash position now makes sense, particularly for those nearing or in retirement.
Related investing topics
The Best S&P 500 Index FundsMultiple index funds track the S&P 500. Which ones are the best investments for you?
Investing in Artificial Intelligence (AI) ETFsIt may be smart to consider investing in one of these artificial intelligence-oriented ETFs.
The power of compounding interestCompounding interest can turn meager investments into wealth over time, but only if you start investing as soon as possible and stay invested. The sooner you start investing, the more time you have for interest to compound.The $1,000 investment in the example above increased by $983 from the fifth year to the 10th year and by $7,064 from year 25 to year 30. The longer you wait to start investing, the older you will be when you reach year 30.
But heed Charlie Munger's wisdom: "The first rule of compounding is to never interrupt it unnecessarily."