Whether you're an investor or a borrower, you'll want to pay careful attention to the interest rate you're earning or paying.
Why is the interest rate so important? Other than the fact it becomes a source of income or the cost associated with you borrowing money, the calculation of interest rates occurs in different ways.
Surprisingly, the way financial institutions calculate interest has a significant impact on how much you earn or how much extra you pay a lender. The two most common interest rate concepts are simple interest and compound interest.
Let's look at these two concepts and compare them.
Simple interest is the easiest way to calculate interest. Let’s say you purchase a Certificate of Deposit for $10,000 from the bank with an effective, simple interest rate of 3% per year. We’ll further assume the bank agrees to pay your interest every quarter.
When you earn simple interest, you receive it directly. It's not added to your investment balance. With an annual rate of 3%, you would get 0.75% each quarter or dollar value of $75.
In this simple interest example, you would earn a total of $300 per year.
$10,000 x 3% = $300 / 4 quarters = $75/quarter
Let’s take the same $10,000 investment and a 3% interest rate and look at the effect of compounding.
When interest is earned under a compounding model, the interest is not paid out. Instead, interest earned is added to the principal balance of the investment.
When calculating the next interest payment, they use the new and higher principle. Compounding can be done for any length of time, including constantly, daily, weekly, monthly, quarterly, semi-annually, and annually.
For this example and comparison purposes, the interest will be calculated quarterly for one year as it was in the simple interest example above.
Here's the calculation:
- Qtr 1: 0.75% x $10,000 = $75 (the $75 is now added to the investment balance, making it $10,075)
- Qtr 2: 0.75% x $10,075 = $75.56 (the $75.56 is now added to the investment balance, making it $10,150.56)
- Qtr 3: 0.75% x $10,150.56 = $76.13 (the $76.13 is now added to the investment balance, making it $10,226.69)
- Qtr 4: 0.75% x $10,226.69 = $76.70 (the $76.70 is now added to the investment balance, making it $10,303.39)
In this compound interest example, you would earn $303.39 per year.
By comparison, you should now be able to see you earned an extra $3.39 ($303.39 – $300) with compounding interest. While it might seem like an insignificant amount, the additional $3.39 is better in your bank account than in the bank's account.
But there’s more to it! This is just an example to show the difference between two different ways to calculate interest.
Keep reading to learn more about the “magic” of compound interest.
Compound Interest Can Grow Your Wealth Exponentially
It makes sense that increasing the original amount of your principal investment, contributing more to the principal investment, or investing at higher interest rates makes you more money.
But time is the critical factor in building wealth through compounding.
The earlier you start putting your money to work for you, the more you’ll earn. And you might find this hard to believe – but the time the money has to compound matters more than how much you save!
As you keep earning interest on top of interest over several decades, you’ll see the power of compound interest – even if you never add more money to the initial investment.
Let’s look at an example of compounding over a much more extended period.
Initial investment = $10,000
Extra contributions = $0
Length of time investment period = 15 years
Interest rate = 4%
Compounding frequency = Monthly
Your initial $10,000 investment without any extra contributions resulted in your savings reaching $18,203.02 – an increase of over $8,000.
You may have noticed that leaving your money untouched for another 15 years (a total of 30 years), would give you $33,134.98 – an increase of over $23,000 without adding any more money to the initial investment.
Even though the length of time you invested doubled (from 15 to 30 years), your savings almost tripled in that time ($8,000 to $23,000).
Since you would hopefully add to your investments over time (whenever possible), let’s take a look at how much you would save if you used the same initial investment but contributed an extra $3,000 a year ($250/month) for those 30 years.
Your total contributions would equal $100,000. But your savings would grow to $206,647.33 – an increase of over $106,000 over those 30 years!
It’s never too late to start saving money. But waiting to invest means compounding interest has less time to work its magic. Just take a look at years 20-30 on the graphs to see how much your money grows when investing for long periods.
That’s the power of compounding.
Compounding interest helps your early years of investing “snowball.” Making it tougher for people who start later to catch up. Even if you got a late start – the sooner you can start saving, the better.
Investing early and often will grow your wealth without much extra effort.
Try A Compound Interest Calculator To See It For Yourself
To see first hand how compound interest works, try this Compound Interest Calculator from the U.S. Securities and Exchange Commission’s website Investor.gov. It allows you to enter:
- An initial investment
- Monthly contributions (don’t forget to try out 0 at some point to see how your initial investment can still grow to a large sum of money over a long period)
- Length of time (years)
- Estimated interest rate
- Interest rate variation range
- Compounding frequency
After entering information, hit CALCULATE and you’ll see how much the investment would grow over time.
You’ll see the future value and your total contributions in dollars and on a graph. It might surprise you how much your initial contribution grows over the years!
Reset the calculator and play with different values to see why “time is your friend” – if you start investing early!
On another note, if you are considering working with investment professionals, you learn about their background, registration status, and more on the homepage at Investor.Gov too.
Starting to Save Early is Hard But Important
It’s easy to put off saving for the future when you have so many financial issues to address in the present. But looking at the results of compounding over the years should make you realize investing early really pays off in the end.
You can invest in Roth IRAs, employer-sponsored 401(k)s or 403bs, SEP IRAs, or 457 plans. You’ll even see compounding at work as you grow an emergency fund in high-interest online savings accounts like Ally, where they compound interest daily.
The same applies to college accounts for your kids. If you plan to help fund their college education, putting even a small amount away when they are young (and adding to it whenever possible) gives compounding time to work.