What is compound interest? Know the facts before you save or charge
If you have a savings account, you know what interest is. It’s that little extra money the bank pays you to hold your money (and these days, unfortunately, it’s usually a tiny bit).
You also know what the interest is if you have a credit card balance or a loan. In this case, it’s the fees you pay to borrow money.
But interest is often overcharged — it’s more than just a percentage of your original balance. This is called compound interest.
Compound interest is good news if you’re saving money — it could help your balance grow faster. But it’s not such good news if you’re in debt – it could increase what you owe.
That’s why it’s essential to understand compound interest before deciding where and how to save or borrow money. You need to pay attention to how often the interest is compounded. And you should avoid letting your credit card balances grow.
Simple vs Compound
To understand how compound interest works, let’s look at another type of interest: simple interest.
Let’s say you invest $1,000 at 5% annual interest, and you don’t touch that money. After 10 years, you’ll have $1,500—your original investment plus $50 in interest each year for 10 years. After 20 years, you will have $2,000. After 30 years, you will have $2,500. It’s just interest. Interest is only calculated on your initial balance, even though you earn interest every year.
Now suppose you invest the same amount of $1,000 at 5% per year in an account whose interest is compounded annually. After 10 years, you will have $1,629. After 20 years: $2,653. After 30 years: $4,322.
This is what financial professionals sometimes call the “magic of compound interest”. At age 30, you would be $1,822 richer than if you had invested in a simple interest account.
Why? Because compound interest means you earn interest on interest. Each time you earn interest, it is added to your investment balance and future interest is based on that ever-increasing amount.
Now suppose your interest is compounded monthly rather than annually. Instead of $4,322, you will have $4,468 after 30 years. And if your interest is compounded daily, you’ll have $4,481.
The more your interest is added to your balance, the faster your money grows.
(There are tools online to help you calculate how much you can earn with compound interest investments using different variables, like this one from the U.S. Securities and Exchange Commission.)
Most bank savings accounts these days offer compound interest. Yes, their interest rates are generally incredibly low – averaging just 0.07% for a $2,500 deposit as of May 16 – but your money will grow faster with frequently compounded interest.
You’ll do a little better with a certificate of deposit, depending on the length of the term and the amount you’re investing.
Before choosing which account to open, check the details. Find out what is compounding frequency — how often is interest compounded? The more frequent, the better. Additionally, banks may offer different interest rates depending on the amount you invest. Find out if a minimum investment is required.
You can compare compound interest accounts by checking the annual percentage yield (or APY) of each account, which takes into account the capitalization.
don’t be unbalanced
Unfortunately, when you use a credit card or take out certain loans, compound interest also works the other way, making your debt more expensive.
Credit card interest rates tend to be quite high initially. The annual rate averaged about 16.2% in February 2022, according to the Federal Reserve. But on top of that, interest is usually compounded daily based on your average daily balance for a given monthly billing cycle. This interest is constantly added to your card balance.
The good news is that you won’t pay any interest charges if you pay off your credit card balance when your statement arrives each month. But if you can’t get your balance back to zero, pay as much as you can at the start of your billing cycle. This will reduce your average daily card balance for the month, which will lower your interest tab. (Many credit card companies allow you to pay online before the bill arrives, even several times a month.)
Authority to repay principal
Most home loans and car loans are simple interest forms of debt, but they look like compound interest because of the way they are structured. At the start of the loan, most of your monthly payment is spent on interest and less on paying down your loan principal.
This repayment structure – known as the amortization schedule — costs you more in interest than paying down the principal first, especially on a 30-year mortgage. This is because your balance remains high for years. So consider making extra payments on your mortgage principal. This way, you could pay off your loan sooner and save thousands of dollars in interest.
However, you should check with your lender about the prepayment charges associated with your mortgage. Also, make sure that your additional payments are only allocated to principal and not to interest.
Whether you’re looking for compound interest for your savings or debt, knowing what it means is the first step!
Finance FYI is presented by 1st Security Bank.
At 1st Security Bank of Washington, we take a personalized and personal approach to your financial well-being. We live in the communities we serve, so our branches offer tailored solutions to their communities. We believe relationships make the difference, which sets 1st Security Bank apart.