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How Does Compound Interest Work?

How does compound interest work?

Before we get to far ahead of ourselves with “compound interest”, lets quickly cover what just plain old “interest” is. Interest, whether it is you borrowing money for a loan or you earning money from an investment, all gets expressed through what’s called an interest rate or interest percentage.


Let’s say you take out a loan with your local bank to add a pool to your backyard so your kids will actually go outside instead of watching a family on Youtube enjoy their pool! Your bank isn’t a non-profit, therefor they need to make money. They also take a risk anytime they lend money to anyone, so to attempt to cover their risks and stay in business, they have to charge you interest on your loan. Interest is basically rent. You are renting the banks money and paying them an agreed upon rate/payment over an agreed upon period to use it. In the end if all goes well, you get a pool and some happy kids and the bank gets their rent money and everybody is a happy camper!


When you earn interest instead of pay out interest like in the above example, it basically works the same way but with one important difference. You as the investor are the bank. You are the landlord agreeing to rent out your cash to some tenants who need it. Maybe your tenants need to raise some capital so that they can grow their oversees operations. Maybe your tenants need money to continue with a research and development project that will set them up for continual growth. Whatever the reason, when you invest your money, you are hoping to get as much rent money back as possible in the form of earned interest.


What Is Compound Interest?


So we covered what interest is, but what exactly is compound interest and why is it so important?


Some have referred to compound interest as the “interest on your interest”. Let’s look at a hypothetical example of what interest on interest looks like. You invest $1000 in an investment that is earning 10% and has an annual compound period. A compound period refers to how often that investment pays out its interest. In this example this investment only pays out interest once a year. At the end of year 1, your $1,000 investment is now worth $1,100 ($1,000 + 10% of $1,000 which is $100). Let’s say you don’t add any additional funds into this investment and instead just leave the $1,100 in your account for another year. At the end of year 2 how much money do you have? The answer is $1,210! You now earned interest on your interest because you left the interest you earned after one year in your account and rather than $1,000 + 10% of $1,000 it is now $1,100 + 10% of $1,100 which equals the $1,210. Take a look at the chart below to see the amazing impact of compound interest.

 

YearsInvestmentInterest EarnedTotal Value
1$1,000$100$1,100
2$110$1,210
3$121$1,331
4$133$1,464
5$146$1,610
6$161$1,771
7$177$1,948
In seven years you almost doubled your money with one single lump sum investment and all you had to do was just not touch the interest or principal and let it build on itself. If you took out the interest every year and just left your principal in, it would take you an additional three years to make that same amount. Let’s look at the same example from above but rather than just one lump sum of $1,000, you invest $1,000 every year and again leave the interest in your account.
YearsInvestmentInterest EarnedTotal Value
1$1000$100$1,100
2$1k + $1,100$210$2,310
3$1k + $2,310$331$3,641
4$1k + $3,641$464$5,105
5$1k + $5,105$611$6,716
6$1k + $6,716$772$8,847
7$1k + $8,487$949$10,436
With contributions of $1,000 every year instead of one lump sum in year 1, your earnings go from a total of $948 in seven years to $3,436! As you can see, if your interest rates earned remained the same, generally the more you invest the more you will make. Compound interest can significantly boost investment returns over the long term. If you made a one time $100,000 deposit at a 5% simple annual interest rate, not compound, you would earn $50,000 in total interest over 10 years. The annual compound interest of 5% on $100,000 would amount to $62,890 over the same period or an increase of $12,890. If the compounding period were instead paid monthly over the same 10-year period at 5% compound interest, the total interest would instead grow to $64,710.

Compound Interest Schedules

Interest can be compounded on a variety of timelines from daily to annually. There are usually standard schedules for each financial investment type. 

The commonly used compounding schedule for savings accounts at banks is daily. For a CD it’s either daily, monthly, or semiannually; for money market accounts, it’s often daily. For home mortgage loans, home equity loans, personal business loans, or credit card accounts, the most commonly applied compounding schedule is monthly. 

When looking at compound interest, the number of periods can make a significant difference. Generally speaking the more compound periods, the greater the amount of compound interest you will receive.

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