What is compound interest?
By definition, compound interest is interest paid on any principal and interest paid thereafter.
Basically, you put money into a savings account, money market account, CD, etc. – this is your principal. Your principal then earns interest. With compound interest, the interest you’ve already earned also earns more interest!
How does compound interest work?
Here’s a simple example: You deposit $1,000 into a money market account, and this money market account hypothetically pays 5% interest.
- After 1 year, you have earned 5% of $1,000 in interest – or $50.
- Starting the next year, your principal is now $1,050.
- In the next year, you will earn 5% of $1,050 – or $52.50.
The example above uses annual compounding. In other words, once per year, the interest accrued so far is added back to the principal and begins earning interest itself.
It may not seem like much of a big deal from the example above – that was only an extra $2.50. However, the effect really starts to snowball, and the value of your investment can begin to increase exponentially over time.
- Starting Principal – The amount of money you initially put in the investment or interest-bearing account.
- Interest Rate – The expected interest rate (or percentage return) you will receive on the money. These days, most savings accounts offer less than 1%, some might offer a couple percent. Stocks and equities may yield 7-10%.
- Number of Years – The time that you will hold the investment.
- Compounding Frequency – How often interest accrued is rolled back into the principal. This is typically how often the interest is paid. For example, it would be monthly compounding if a savings account pays you interest on a monthly basis. Stock prices change every day, but it is most accurate to treat this as annual compounding (your projected return is annualized).
- Contribution Amount (optional) – If you plan to keep contributing money to this account or investment, enter that amount here.
- Contribution Frequency (optional) – How often you are making an additional contribution. For example, $6,000 annually to a Roth IRA.
- Final Amount – The projected future value of your investment. Try adding another 10 years to really see the effects of compound interest.