What is compound interest?
Compound interest refers to the addition of earned interest to the principal balance of your account. Each time interest is earned, it is then added to your principal balance. Your new balance becomes the combined total of your earned interest and your original deposit. Each additional payment period, interest is then calculated based on the full value of your account, including previously earned interest. This is often compared to creating a snowball effect, as the initial deposit and interest earnings are continuously working together to grow your savings.
How does it work?
To further understand on how compounding works, let’s start by recognizing the key terms involved:
- Principal: Your initial deposit. The amount you originally save or invest. It will determine how much interest you earn. The more you initially put down, the higher the interest earnings.
- Interest rate: The percentage that determines how much interest you will earn. A higher interest rate means more earnings added at the end of each interest payment period.
- Compounding frequency: The number of times the interest compounds each year, which could be daily, monthly, semi-annually, annually, etc. Compounding more frequently will see faster growth.
- Timeframe: The total amount of years. The sooner you begin compounding and the longer you let it accumulate, the more growth you will see.
The importance of time
Over time, as the interest grows at each interest payment period, earnings will begin to accumulate more rapidly leading to exponential growth. The sooner you are able to put your money toward compounding, the more time it allows the compound interest to accumulate.
For example, if you make an initial deposit of $1,000 into an account with an annual interest rate of 1%, assuming you make no withdrawals, the following will occur:
- In Year 1, you will earn $10 from interest, increasing your balance to $1,010.
- In Year 2, your balance of $1,010 earns $10.10 from the annual interest rate of 1%, making your balance $1,020.10.
- In Year 3, your $1,020.10 will earn $10.20 from the annual interest rate of 1%, for a new balance of $1,030.30.
Now watch compound interest work if you made an initial deposit of $1,000 into an account with an annual interest rate of 1% while contributing an additional $1,000 per year:
- In Year 5, if you deposit $1,000 each year, totaling $5,000 in year 5, you will earn $152.01 from interest, making your balance $5,152.01.
- In Year 10, if you deposit $1,000 each year, totaling $10,000 in year 10, you will earn $566.84 from interest, increasing your balance to $10,566.84.
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