Compound Interest: The Basics of How It Works and Why You Should Care

Compound Interest: The Basics of How It Works and Why You Should Care

August 29, 2022
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When we’re kids, most of us are told that if we save our money in a bank or some other type of investment, it will grow and make more money for us. But how does that actually happen? In what way does your money grow? What does "compound interest" mean? And why should you care about this stuff? These might seem like strange questions to ask about something as simple as saving money, but understanding the answers to these questions can have a big impact on your financial future. Compound interest is essentially the process by which the principal amount of an investment grows faster over time due to reinvestment of interest or dividends into new shares or additional principal. This article will give you everything you need to know about compound interest and how it can work in your favor.

What is compound interest?

Compound interest is the process by which the principal amount of an investment grows faster over time due to reinvestment of interest or dividends into new shares or additional principal. Compounding is the process of earning interest on previously earned interest. This is why it’s called “compounding” interest. In other words, compound interest is the process by which the initial amount of your investment grows at a rate far greater than the initial interest rate you earn on the investment.

How does compound interest work?

If you invest $1,000 and earn 10% interest for a year, you will earn $100 in interest on the $1,000 initial principal. But then you will also earn 10% interest on the $100 interest you just earned, so you will actually earn $110 in total. Let’s say you put $1,000 into an investment that earns 10% interest annually. After one year you will have $1,100. That $100 increase is called the “principal.” Meanwhile, the $10 increase in “interest” is called the “compound interest.”

Why is compound interest important?

You might be wondering why you should care about an investment’s ability to earn compound interest. After all, this is a very basic concept that applies to all investments, regardless of category. The main reason to understand how compound interest works is that it can have a big impact on the amount of money you will have saved for retirement or any other long-term financial goal. For example, let’s say you have two friends who are both 35 years old and saving $100 per month towards their retirement. One friend invests in a mutual fund that earns 6% annually, while another friend invests in a different mutual fund that earns 12% annually. At the end of 30 years, the friend with the higher-earning mutual fund will have an extra $250,000 saved compared to the friend who earned a lower interest rate.

´╗┐When does compound interest matter the most?

The compound interest formula is the same for all investments, but the impact of compounding is not the same for all types of investments. For example, stocks and other equity-based investments tend to earn compound interest over long periods of time, while cash-based investments like savings accounts earn compound interest over a short period of time. As a result, people often choose to save money in cash-based investments, like a savings account, for the short-term. But those who are saving for a long-term goal, such as retirement, often choose to save money in equity-based investments, like stocks, to take advantage of the compound interest over a longer period of time.

How to use compound interest to your advantage?

Of course, you can’t force your investments to earn more interest. But there are a few things you can do to increase the likelihood your investments will earn compound interest over a longer period of time. First, you may invest in a wide variety of stocks, bonds, and funds to reduce your overall investment risk. This balanced approach tends to help mitigate losses in a bad economy. The next step to consider would be time in the market. If you sell your stocks or funds after just a few years, you may miss out on the compound interest that could have made a big impact on your savings. You can hold your investments for the long term by investing in a diversified portfolio of stocks and funds, and then setting up an investment plan to check in on your progress regularly.

Bottom line

Compound interest is the process by which the initial amount of your investment grows at a rate far greater than the initial interest rate you earn on the investment. The main reason to understand how compound interest works is that it can have a big impact on the amount of money you will have saved for retirement or any other long-term financial goal. The formula for compound interest is the same for all investments, but the impact of compounding is not the same for all types of investments. To find out what type of investments might be suitable for you, contact a local financial advisor in your area and set up a 1 on 1 consultation.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision. 

These are hypothetical examples and not representative of any specific investment. Your results may vary.