Compound interest is interest that is paid on other interest. If you are earning compound interest on a deposit, the interest you have earned during a fixed compounding period is added to the sum you have on deposit. In the next compounding period, you will earn interest not only on your deposit but on the interest that’s been added to it. Each time the interest compounds your principal grows and the larger principal earns more interest.
Compound interest can also be charged on loans. If you are paying compound interest on a loan or credit card balance, each time the interest compounds it is added to your balance, and in the next compounding period, you pay interest on the total, including the previously compounded interest. Just as compound interest on a deposit can help you make money, compound interest on a loan can help a lender make money from you.
Knowing how compound interest can work for and against you can help you maximize its advantages and minimize its disadvantages.
How Are Simple Interest and Compound Interest Different?
If you deposit money in an interest-bearing account, you will earn either simple interest or compound interest.
Simple interest is a percentage of the principal amount, paid annually. For example, if you deposited $10,000 at a simple interest rate of 4%, your interest would be $400 every year. At the end of 10 years, the total balance of your deposit would be $14,000.
If your account pays compound interest, each interest payment is added to the principal. Imagine that you have that same $10,000 on deposit at 4% interest. If your interest is compounded annually, at the end of the first year you will have $10,400 on deposit, and in the second year, you will earn interest on that amount. After 10 years you’ll have $14,802.
Every account that pays compound interest has a compound frequency. The more frequently the interest is compounded, the more you will earn. If your interest is compounded weekly, your interest for each week will be added to your principal, and the principal amount for the next week will be slightly larger.
If you have $10,000 on deposit at 4% and your interest is compounded weekly instead of annually, your balance at the end of 10 years will be $4,915.95.
Compound Interest on Debt
Loans and other forms of debt also bear either simple or compound interest. When you deposit money, a bank pays you interest. When you borrow money, you pay interest to the lender. It’s what you pay for the privilege of using their money. Just as compound interest can increase the amount you earn on a deposit, it can also increase the amount you pay on a loan.
Calculating interest on loans is less straightforward than calculating interest on long-term deposits because you make monthly payments on a loan, so your principal is reduced each month. The same concept applies: if your loan carries compound interest you will pay interest on any interest that accrues to your account.
At the end of every compounding period, the interest that your loan has accrued will be added to the principal amount that you owe. In the next compounding period, you will pay interest on both the principal amount and the interest that has been added to it.
If your monthly payment does not cover the interest on the loan you may experience negative amortization, which means that your loan balance will get larger over time, not smaller.
Compound Interest and Credit Card Debt
Compound interest is one of several factors that make credit card debt so dangerous:
- High-interest rates. Credit cards carry high-interest rates. The average American mortgage has an interest rate of around 4.5%. The Average American car loan has an interest rate of around 5.27%. The average American credit card carries a rate of 19.02% for new offers and 15.10% for existing cards.
- Low minimum payments. Credit cards usually have low minimum payments. Making that minimum payment will keep your account in good standing, but you’ll roll that balance over to the next payment period and you’ll pay interest on it. That low minimum payment makes it easy to run up a large interest-bearing balance.
- Compound interest with daily compounding. Credit cards carry compound interest, and in most cases, the interest is compounded daily. Card issuers know what compound interest can do and they use it in their own interest which is not the same as your interest!
This combination can make credit card debt very profitable for lenders and very costly for borrowers. Low minimum payments make it easy for debtors to push payment of a balance back. Once the balance is rolled over to the next statement period, the combination of a high-interest rate and daily compounding increases the amount owed very quickly.
What Makes Compound Interest Work?
Compound interest may seem to work slowly, and the difference between compound and simple interest may seem small. There are several features that influence the impact of compound interest, whether you’re earning it or paying it.
- Frequency. The more frequently interest is compounded, the greater the influence of compound interest.
- Time. The longer an amount accumulates interest, the more interest will be involved. Compounding accelerates that accumulation.
- Interest rate. The rate is the percentage of the principal that is paid each time the interest compounds. Compound interest adds to the principal each time it is paid, but it doesn’t change the rate. The higher the rate, the faster the principal will grow.
- Payments, deposits and withdrawals. If you have savings on deposit, it will grow faster with compound interest than it would with simple interest. It will grow fastest if it earns compound interest and you add to your savings regularly. If you withdraw occasionally your savings probably won’t grow at all.
You can diminish the impact of compound interest on a loan balance by making regular payments: the larger the payment, the better.
If you’re aware of these factors, you can help compound interest work for you and prevent it from working against you.
In Closing
Compound interest is an attractive feature when you’re earning it and a less attractive feature when you’re paying it. Understanding compound interest can help you take advantage of the opportunities it offers and avoid the penalties it can impose.
