Compound interest is a key factor in long-term financial planning. This powerful concept can significantly grow your money over time. Unlike simple interest, which is calculated only on the initial sum, compound interest is figured on the initial sum, plus all previously earned interest. Learn more about using compound interest to exponentially increase investments.
The Basics of Compound Interest
Compound interest is earned on both the initial amount of money, known as the principal, and the added interest. It can be illustrated with the following formula: A = P (1 + r/n)nt
- A is the amount of money accrued after “n” years, plus interest
- P is the principal amount or initial sum of money
- r is the annual interest rate, represented by a decimal
- n is the number of times that interest is compounded per year
- t is the number of years the money is invested
The Power of Time
The longer you invest your money, the larger the growth. Each compounding period adds more interest to the principal sum, creating a snowball effect for the duration.
For example, if you invest $1,000 at an annual rate of 5% interest compounded annually, you will have $1,050 after one year. After the second year, the interest earned on $1,050 totals $1,102.50. As this compounding effect continues, the growth of your investment increases.
Frequency Is Key
The more frequently interest is added to the principal sum, the faster your money will grow. It can be compounded in annual, semi-annual, quarterly, monthly or daily intervals.
For instance, if the $1,000 investment at 5% interest is compounded quarterly, the total after one year will be $1,050.95. Although the difference may seem small initially, the benefits of frequent compounding can become substantial over many years.
Real World Applications
Compound interest can be applied to various financial products such as savings accounts, certificates of deposits, bonds and retirement accounts. Understanding how compound interest works can help you make more informed investment choices and maximize the growth of your assets.
For example, consider a 401(k). Regular contributions to this retirement account, combined with the power of compound interest, can lead to a significant nest egg over the course of your career. If you start with a $5,000 initial investment and contribute $200 monthly at an annual interest rate of 6% compounded monthly, you will have $231,015.88 after 30 years.
Try our online calculator and see how “interest on interest” could increase your savings!