Understanding compound interest and its power

Understanding compound interest and its power

06.14.2024

With 80% of Americans making investments a priority this year, the concept of compounding has the potential to be a powerful tool in people's portfolios. 

What is compound interest? 

Simply put, compound interest is the interest you earn on your interest.

This can help money grow faster because rather than only earning interest on your principal balance, you also earn interest on the interest you earn along the way. The more time that passes, the more time compound interest has to work and grow your savings. 

Compound interest vs. simple interest 

The other type of interest is simple interest. Simple interest is only earned on the principal balance, unlike compound interest, which also applies to the interest that’s accumulated. 

Compound interest applies to deposit accounts like savings accounts and typically to certificates of deposit (CDs) as well. Simple interest, on the other hand, most often applies to loans. When you take out a personal loan, interest only ever applies to your principal balance. It also doesn’t apply to the interest you’ve accrued on the loan. 

How compound interest works 

Compound interest occurs when the interest you’ve earned on your savings also begins to earn interest. At the end of a compounding period, your interest is added to your principal balance. Therefore, in each compounding period, the amount of money accruing interest is larger than in the previous period, resulting in greater interest earnings, allowing your money to grow more quickly. 

Compound interest formula 

Compound interest is calculated using the following formula: Compound Interest = P[(1 + r/n) ^ nt 

Read more: What is an interest rate? 

Compound interest vs. compound earnings 

Compound interest can apply to all sorts of bank accounts, from your savings account to your credit cards. We’ve talked about some of the various accounts that may earn compound interest, including savings accounts and CDs.  

Earnings in stock investing works a bit differently. Investment accounts are not bank accounts and stocks held in investment accounts do not gain interest – rather some earn dividends and can experience capital appreciation. For example, if a stock investment paid you a 4% annual dividend yield and the stock itself increased in value by 5% for the year, you’d earn a 9% return for the year. 

Compound earnings in investing 

The best way to illustrate how compound earnings work is through a real-life example.  

Suppose you contributed $10,000 to your retirement account, which was allocated to investments that returned 8% for the year. In the first year, your investments returned $800 and your account is now worth $10,800. In the second year, rather than earning returns on only your initial $10,000, you’ll earn returns on $10,800 — your initial investment plus the returns you’ve already earned. 

The power of compounding grows significantly over time. Let’s take a hypothetical example: Say you invested that initial $10,000 when you were 25 and let it grow for 40 years until you were 65 and ready to retire. 

If you accrued only simple interest at an 8% interest rate, you would end up with just $42,000. But with compound earnings (assuming an annual rate of return of 8%), you would end up with more than $217,000 — and that’s all without contributing another dollar. As you can imagine, the result could be even more impressive if you made regular contributions.  


There are a few other specific ways that compounding can apply to your investments. 

Dividend reinvestment plans (DRIPs) 

A dividend reinvestment plan (DRIP) is an effective way to use the power of compounding in your investment account. When you sign up for a DRIP, you automatically reinvest your dividends each year back into the stock or fund that paid the dividend. This has a compounding effect because the reinvested dividends are added to your investment value, and that money also earns dividends. 

Zero-coupon bonds 

Another way you can earn compound interest in your portfolio is through zero-coupon bonds. Traditional bonds pay interest on your principal investment, but that interest doesn’t compound. Zero-coupon bonds, on the other hand, don’t technically pay interest. However, they still have a compounding effect because you purchase them at a discount, and their value rises over time. 

Estimating your returns over time 

The Rule of 72 is a useful tool that can be used to estimate your investment returns over time. To use this tool, divide the number 72 by your expected investment return. The resulting number is the number of years it could take your investment to double. 

This rule requires you to know your investment returns, which isn’t always possible. The stock market is unpredictable, and the returns change each year. Even in a savings account where the interest rate is stated, you can expect it to change with the market. 

According to Securities and Exchange Commission (SEC) data, the stock market has historically provided an average annual return of about 10%.1 Once you account for inflation, it’s between 6% and 7%. 

So, let’s say you want to calculate how much time it could take for your investments to double, assuming the average stock market return. To calculate that number, you would divide 72 by 10 (your expected return). The result tells us that it could take just over seven years for your investments to double. 

Of course, that doesn’t mean your investments are always growing by the same amount. If you invested $10,000 in the first seven-year period, your investments could double to $20,000. But in the second seven-year period, they could grow from $20,000 to $40,000 — that’s double the earnings of the first seven years, which shows you just how powerful compound earnings can be. 

Read more: What is the rule of 72? 

Start saving early 

As you can see, compound earnings can have a powerful impact on your investments over time. For that reason, it’s critical that you start saving and investing as early as possible.  

Let’s say you started saving for retirement at age 25. You save $100 per month in an investment account that earns an average of 10% per year (the historical stock market average). If you plan to retire at 65, you could retire with more than $530,000. By increasing that number to $200 per month, you could return with more than $1 million. 

But what if you waited until age 45? Assuming the same $100 per month contribution, you could retire with just shy of $69,000. In fact, compound earnings are so powerful that if you started at age 45, you would have to contribute nearly $800 per month to retire with the same amount as if you had saved $100 per month starting at age 25. And if you wanted to retire with $1 million saved, you’d have to invest nearly $1,500 per month. 

Compound interest on debt 

Just as compounding can work in your favor, it can also work against you if you have debt with compounding interest. In most cases, loans such as mortgages, auto loans, and personal loans have simple interest, meaning it doesn’t compound. 

Credit cards, on the other hand, charge compound interest. That, combined with their high interest rates, is why it’s so difficult to get out of credit card debt. If you feel like you’re making large payments on your credit card bill each month, but the balance doesn’t seem to budge, it’s because your credit card interest is compounding each day. In other words, your balance literally grows every day. 

It can be helpful to keep this compounding interest in mind when considering your savings and debt-payoff strategy. Because of the compounding interest on credit cards, it can be worth prioritizing paying those off over other savings goals and over other debt payoff. 

How compounding periods work 

One of the most important aspects of compounding is your compounding period. Your compounding period is the frequency with which you accrue interest on your investments. Different accounts may have different compounding periods, such as daily, monthly, quarterly, or annually. Some accounts compound daily but only credit the interest to your account monthly. 

Different types of savings compound at different periods. Savings accounts at banks often compound daily and pay credit interest to your account monthly. CDs, on the other hand, may compound either daily or monthly, depending on your account. Though many bonds don’t compound, Series I bonds often compound semiannually, meaning every six months. 

On the other end of the spectrum, interest on credit cards generally compounds daily, while interest on loans may compound monthly (though it’s worth noting that most loans charge simple interest). 

The frequency with which your account compounds can impact your earnings. If you had $10,000 in a savings account that compounded annually (which isn’t usually the case), you would earn $500 in interest throughout the year. If interest compounded daily, you would earn $512 in interest throughout the year. Though that’s not a substantial difference, it would become more substantial over time as your account balance grows. 

Pros and cons of compound interest and earnings 

The benefit of compounding is clear — it can help your savings grow more quickly, helping you to build wealth and reach your goals faster. That’s why investing can be the single best way to save for retirement. Thanks to compounding, the amount you’ll end up with is far greater than the amount you actually invested. 

Compound earnings can also serve as a form of risk mitigation, helping to offset the wealth erosion that happens as a result of inflation. This is especially important for long-term savings such as retirement. 

Read more: How to prepare for inflation 

Of course. Compounding can also work against you. First, because of the way compounding works, if you postpone saving for retirement, you’re at a significant disadvantage. It’s not necessarily the missed contributions that hurt you, but the years of compounding. 

Compound interest also works against you when you’re working to pay off debt. If you have credit card debt, as many Americans do, then your balance grows each day as a result of compound interest. Unless you’re paying more than your minimum payment each month, it could take years — or even decades — to get rid of your debt. 

Tools for calculating compound interest 

As you’re planning your savings and investments, it can be helpful to calculate your estimated compound interest or earnings to get an idea of how much your balance will grow over time. There are ways to calculate compound returns using a spreadsheet, by using either a fixed formula or by using a macro function to automate your calculations. 

That being said, the easiest way to calculate compound returns is by using an online calculator. The SEC offers a compound interest calculator at Investor.gov.  

You enter your initial savings amount, monthly contribution, time horizon, and estimated interest rate, and you can see how much your balance will grow using either daily, monthly, quarterly, semiannual, or annual compounding. You can also use an interest rate variance range to see how your compounding would vary if your returns were slightly higher or slightly lower than anticipated.  

Who benefits from compound interest and earnings? 

Compound interest most often benefits consumers. Most deposit accounts, including savings accounts and CDs, pay compound interest. Additionally, there are several different ways your earnings compound when you’re investing, whether it’s by the rise of stock prices over time, reinvesting your dividends, or investing in bonds that pay compound interest. 

On the other hand, lenders may also benefit from compound interest. Though most loans charge simple interest, credit cards charge compound interest, which allows credit card issuers to earn substantial profits from their customers’ unpaid debt balances. 

The bottom line 

Compounding is one of the most important concepts in personal finance. It can work either for you or against you. When it’s working against you, compound interest can cost you more money and significantly increase the amount of time it takes you to repay your debt. But when it’s working for you, compound interest or earnings can exponentially increase your savings and help you reach your long-term financial goals, including retirement. 

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Stay current on planning, saving, and investing for life.

Investing involves risk, including possible loss of principal. 

The rule of 72 is a mathematical rule used to approximate the number of years it takes a given investment to double in value. It assumes a constant rate of return. Rates of return may vary. This principal does not reflect any associated charges, expenses, or fees, which could change the outcomes provided. 

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1 SEC, “Securities and Investing,” June 2011. 

Jeremiah Forrest, CFP®

Contributor

Jeremiah Forrest is a Senior Financial Professional at Empower. A CERTIFIED FINANCIAL PLANNER™ professional, he works with Empower Personal Wealth investment clients and provides a wide range of financial planning services for clients who are enrolled in the Personal Strategy managed asset program. 

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