If your child asked you what compound interest is and how it works, would you be able to answer them? If you answered no, you’re not alone.
Unfortunately, the majority of Americans don’t understand how compound interest works, yet it’s one of the most important financial concepts to grasp. Albert Einstein agreed when he called compound interest the 8th wonder of the universe. After all, compound interest can cause your wealth to snowball and help you save hundreds of thousands of dollars. But you don’t need to be a world-famous mathematician to understand compounding interest.
Check out the video above for a visual example of how this financial concept works. Or better yet, visit our interactive savings account workshop to learn about the basics of compound interest and other ways to boost your savings.
Below, we’ll take a look at the difference between simple and compound interest, explain how the latter works, and how you can use this financial concept to make your money grow.
How Interest Works With Savings Accounts
Savings accounts can earn interest in one of two ways: through simple interest or compound interest.
With simple interest, you only earn interest on your principal (or the amount you have in the bank). For example, if you have $1,000 in a savings account that earns 5% simple interest per year, you would earn $50 a year for a grand total of $1,050. That’s all the interest you earn. No more, no less.
Compound interest works a lot differently and is generally a better way to grow your money.
How Compound Interest Grows Your Savings Account
Unlike simple interest, compound interest allows you to earn interest on both the money you’ve saved and the interest you earn. Essentially, you earn interest on your interest.
The interval at which that interest compounds varies from bank to bank. With some accounts, interest compounds daily, weekly or monthly; other accounts compound semi-annually or annually. And the shorter the interval, the more quickly the principal will grow.
Let’s use our $1,000 example from earlier and add it to a compound interest-bearing account that also earns 5% interest once a year. At the end of the first year, you would have $1,050. But after 20 years, your savings would grow to $2,653.30. With a simple savings account, you would only earn $2000 during the same time span.
The lesson is that compound interest will always grow your savings faster than simple interest.
With Compound Interest, Time Is Power
With compound interest, the power of time is everything. To take full advantage of the power of compound interest, savings must be allowed to grow and compound for long periods.
That’s because for each compounding period, you earn more interest than you did before—even if you haven’t made any new contributions to your savings. However, it’s a good idea to make regular contributions, no matter how small. When you contribute faithfully to your savings account throughout the course of the year, you’ll dramatically boost the compounding effect.
The Higher The Interest Rate, The Better
The easiest way to take advantage of all the benefits of compound interest is to open a savings account—and the higher the interest rate, the better. High-yield savings accounts generally offer higher interest rates than regular savings accounts. Certificates of deposit (CDs), 401ks, and money market accounts also typically pay compound interest, giving you more opportunities to let your money work for you.
How Compound Interest Can Affect Your Future
As you can see, the sooner you start saving the longer you give that money to grow. That’s why it’s important to start investing as soon as possible. The earlier you start, the more time you have to grow your savings for retirement, a home purchase, or a rainy day fund.
Ready to Start Making Your Savings Work For You? Check Out TFNB's Saving Accounts
Compound interest is a fascinating phenomenon that can transform even a small amount of money into a large sum over time. Now that you know how compound interest works, maybe it’s time to apply it to your finances.
Stop by one of our locations and talk to a friendly TFNB banker about how you can start making your money work for you. At TFNB, we offer everything from high-interest CDs to high-yield savings accounts with rates that beat the national average. No matter your savings goals, we’re here to help you reach a bright financial future. That’s why TFNB is your bank for life.
If you have any questions or would like to know more about our banking solutions, contact us at 254-840-2836
