How much money would you have after three years if you started with $10,000 and earned 5% interest each year? Most people would say they have $11,500.
What if your interest compounded every month instead of earning 5% each year? You would have more than $11,600.
The difference may seem small, but it can add up over time. This is just one example of how compound interest can work in your favor - or against you. Let's look at compound interest and how it works.
Simple interest
Simple interest is what your money would earn once at the end of a term. For example, if $100 earned 10% interest at the end of a year, you would have $110.
With simple interest, the interest earned each year is based only on the original amount of money. So, in the second year, instead of earning interest on the original $100 investment plus the first year's $10, you would only earn interest on the initial $100 investment.
Compound interest
Compounded interest is interest that is calculated not only on the initial principal, but also on the accumulated interest of previous periods. That's why it's called "compounding."
So, if you had $100 and earned 10% interest at the end of the year, you would have $110. But then you would have $110 for the following year. And at the end of the second year, you would have $121 - 10% added to $110.
With compound interest, the interest you earn each year is based on the original amount of money you had plus the interest you earned in previous years. Compounding can occur daily, monthly, quarterly, semi-annually, or annually. The more frequently compounding occurs, the greater the impact on your money.
Simple interest vs. compound interest
Compound interest is different from simple interest in that it builds on itself, meaning the interest you earn each year is not only based on the original amount of money you had but also on the subsequent interest accrued.
To see how compound interest works, let's compare it to simple interest. We'll use three hypothetical investments - annual compounding, semi-annual compounding, and simple compounding.
All investments start with $10,000 and earn 5% interest per year (paid monthly in the case of the compound interest investment). In our example, if interest compounds monthly, you would have $110.41 at the end of the first year ($100 x 1.008333) and $121.68 at the end of the second year ($110.41 x 1.008333).
The example below shows how compounding interest can grow your money more quickly than simple interest.
As you can see, the sooner you start saving and investing, the more time your money has to grow with compound interest. And the more frequently compounding occurs, the more significant the impact on your money.
Compound interest can be an investor's best friend or worst enemy. It all depends on whether you're earning or paying. If you're lucky enough to be earning, compound interest will work its magic, steadily growing invested money over time.
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