How Does Compounding Interest Work? (Basic Guide)

In the financial world, there are a lot of different buzzwords and terms that get thrown around, and sometimes you need a basic refresher on what all these words mean. You may vaguely recall the term ‘compounding interest’ from a finance class in school, but unless you paid very close attention, you probably don’t truly understand what it means. The good news for you is that we’ll break down in this piece what exactly is compounding interest and how it may affect you. So, let’s get into it.

Compound Interest Defined

Compound interest is interest paid on the initial principal value, as well as the accumulated interest on money that you have borrowed. In other words, its interest on interest.

Think of compound interest as the ice cream sprinkles of your savings. Regardless of how the economy is doing or whether the stock market is in good shape or not, you can always count on compounding interest.

In real life situations, compound interest is often a factor in business transactions, investments, and financial products intended to extend for multiple periods or years.

Compound Interest Formula

If you thought you were going to read through this piece without diving into a formula, then you were sorely mistaken. But have no fear, the compound interest formula is quite simple.

Compound Interest Formula

A = P(1+r/n)^nt

Don’t worry, it is more simple than it looks.

A = Amount (or total $)

P= Principal

r = interest rate (decimal)

n = Number of times interest is compounded per year

nt = time (years)

So, What Does That Mean For You?

Let’s look at a basic example to see just how this may affect you. You can also watch the video version of this example courtesy of One Minute Economics.

Jim and Jane are looking for a bank to hold their money. A local bank, Northstar, agrees to pay Jim and Jane 10% interest per year. Jim and Jane both agree and decide to put $1,000 each (the principal amount) into a separate account.

Jim is a big spender, so after the interest has been added after the first year, he has $1,100 in his account (10% of 1,000 is 100, so simply add that to the original principal amount). Jim takes out the interest he made ($100) and spends it, leaving his account with $1,000.

The following year, he once again makes that 10% interest on his $1,000, giving him a total of $1,100 at the end of the year. Jim takes out that $100 again, spends it, and is left with $1,000 in his account again.

Jim does this every year for 30 years. So, by the end of those 30 years, he still has $1,000 in his bank account + the value of his assets that he purchased ($100 taken out and spent for 30 years = $3,000), which comes out to $4,000.

Meanwhile, Jane does not take out the $100 after the first year and instead leaves it in her account. Because of compound interest, the next year she doesn’t receive just $100 in interest again, but instead she will receive an additional $110 (10% of $1,100). That will bring her grand total in her account to $1,210.

Jane leaves her money in her account every year for 30 years, and because the interest keeps compounding each year as her money grows, she finishes with $17,454.94, which is much more than Jim has.

So now you see the importance of compounding interest and saving your money.

What About Simple Interest?

You may also have heard of simple interest before, which is interest that is paid only on the principal of a deposit or loan. Here is a quick example to clarify.

If you deposit $1,000 at a bank that offers 5% simple interest every year, then you will have $1,050 after the first year. If you decide to leave all that money in your bank account, the next year you will still receive the interest that the bank agreed to, but ONLY on your principal amount (the $1,000 that you initially deposited).

So, after two years, you will have $1,100 in your bank account. If the bank offered 5% compound interest, then the total after two years would be $1,102.50 (not a substantial difference, but over time it will add up).

Be Smart When it Comes to Saving Money

While it is unlikely you will come across a bank offering 10% compound interest, the point remains that choosing to save your money and avoid spending it can be extremely fruitful down the road. That isn’t to say you have to live extremely frugal. You worked hard to earn your money, and you deserve to splurge on your hobbies and interests. However, you should work with a trusted financial advisor when it comes to planning for the future and making sure you’ll have enough money down the road, especially when you retire.