Hannah Logan
Siddhi Bagwe
Beth Buczynski
Compound interest is the holy grail of saving and investing and, depending on the circumstances, can be much more lucrative than traditional simple interest. Here’s what you need to know about growing your money via compound interest.
How compound interest works
Compound interest allows you to earn more money faster than you would with just simple interest. Compound interest is earned on your original savings as well as the interest income accumulated on those savings.
Interest is compounded at a set frequency, known as the compounding period, that varies depending on the product. The frequency could be daily, weekly, monthly, quarterly or annually. The more often the interest is compounded, the faster your money will grow.
Unlike fluctuating stock market returns, compound interest returns can be projected with a formula, making it easier to know how long you need to save. This is especially handy for specific savings goals, like a wedding, a down payment for a home, or retirement.
However, as lucrative as compound interest can be for things like savings accounts and interest-bearing investments, it can also cost you more when you borrow money. You need to be cautious of taking out debt with compounding interest because the amount you owe will snowball over time.
How to calculate compound interest
The easiest way to calculate compound interest is to use a compound interest calculator. You can find these for free online with a quick Google search (look for one from a reputable source like a bank or government organization). But, if you don’t have that handy, you can also go the old fashioned route and use the following formula:
A = P(1 + r/n)nt
A = total amount you will wind up with at the end of the timeframe (principal plus earned interest)
P = principal amount (your original savings before earning any interest)
r = annual interest rate, written as a decimal
n = number of times the interest compounds each year
t = total number of years in the timeframe
To complete the equation, you will want to
- Divide the annual interest rate, as a decimal, by the number of compounding periods in a year. Add 1 to this number.
- Multiply the number of compounding periods in a year by the number of years in the timeframe.
- Calculate the number in Step 1 to the power (exponent) of the number from Step 2.
- Multiply the result from Step 3 by the original principal amount to get the total principal plus earned interest.
If you want to know how much of that amount is just interest, subtract the original principal.
Compound interest formula explained
Let’s say you want to know how much compound interest $10,000 can earn in a year in a high-interest savings account at an annual interest rate of 2% that is compounded monthly. If you plug these values into the formula, you will get the following:
P = $10,000
r = 0.02 (2%, written as a decimal, 2/100)
n = 12 (compounding periods, monthly)
t = 1 (total number of years in the timeframe)
So:
A = P(1 + r/n)nt
A = $10,000(1+0.02/12)12*1
A = $10,000(1+0.001667)12
A = $10,000(1.001667)^12
A = $10,000 x 1.0202
A = $10,202
At the end of the year, you will have $10,202 in your high-interest savings account. Of that amount, $202 is compound interest earned during the year.
Types of products that use compound interest
As mentioned above, there are all kinds of products that use compound interest. Some work in your favour and others don’t.
These are some of the most common financial products that have compound interest.
Compound vs. simple interest
The main difference between simple interest vs. compound interest is what earns the interest.
The main difference between simple interest vs. compound interest is what earns the interest.
With simple interest, earnings are calculated on the principal only. So if you have a $10,000 deposit earning simple interest, you will earn interest only on that $10,000, no matter how long you have it invested for or how much interest accumulates.
In our compound interest example above, on the other hand, you’d earn interest on the entire $10,202 in the first month of the next year, not just the original $10,000 deposit.
Compound interest is great for saving, so try to find savings accounts or investments that pay compound interest. But compound interest can quickly work against you when it comes to loans and debts, so it’s better to have simple interest in these cases if possible.
» MORE: How does an annual percentage rate (APR) compare to an annual percentage yield (APY)
Frequently asked questions about compound interest
Many Canadian financial institutions usually compound interest rates for savings accounts on a monthly or daily basis. However, this interest compounding frequency, known as the compounding period, varies depending on the product. The more often the interest is compounded, the faster your money will grow.
Compound interest is great for saving when you choose savings accounts or investments that pay compound interest. But compound interest can adversely affect your loans and debts, so it’s better to have simple interest in these cases.
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