What Is Compound Interest and How Does It Work?

There's a saying that the best time to plant a tree is 20 years ago, and the next best time is now. The same can be said about opening a savings account. That's not only because it takes time to sock away enough money to meet your goals, but also because of the way compound interest can grow your savings over time.

What Is Compound Interest?

Compound interest is the accumulated interest to your principal (money in your savings), which then begins earning interest, too. Essentially, it's when the interest starts earning interest of its own.

Simple vs. compound interest

Interest accrued on savings accounts comes in two forms: simple and compound.

Simple interest is paid only on the amounts you save. Compound interest, on the other hand, is paid on both your savings and any previous interest you earned. It's a small but important distinction because, given enough time, compound interest can accelerate your savings and leave you with considerably more.

Think of savings earning compound interest like a snowball rolling down a hill. As it rolls, it picks up more snow and grows bigger and bigger. That's what compound interest does with your money.

How to calculate compound interest

The mathematical formula to calculate compound interest is P (1 + r/n)^nt

P represents your principal or original savings; r is the interest rate expressed as a decimal; n is the number of times interest is compounded per year; t is time in years.

If you plug in the values $3,000 for P, 0.04 for r, 1 for n, and 30 for t, you will get the same amount as in our chart above:

$3,000 (1 + 0.04/1)^{1 x 30}

$3,000 (1 + 0.04)³⁰

$3,000 x 1.04³⁰

$3,000 x 3.24339751003

= $9,730.19

Of course, in the digital age, you can simply use one of the many compound interest calculators found online, such as this one from Investor.gov, to crunch the numbers for you.

Savings Accounts With Compound Interest

If you're seeking a savings account that will accrue interest on your principal, there are multiple to choose from. Each has certain advantages and disadvantages, so it's important to learn more about each one before deciding where you'll put your hard-earned money. Below are some of the most popular types of compound interest accounts currently on the market.

1. High yield savings accounts

• What they are: These accounts pay more interest than regular savings accounts.
• Why use them: Great for emergency funds or saving for short-term goals.

2. Certificates of deposit (CDs)

• What they are: You agree to leave your money in the account for a set time (like six months or five years) and get a higher interest rate.
• Why use them: Perfect for medium-term savings you don't need right away.

3. Money market accounts

• What they are: A mix between a savings account and a checking account.
• Why use them: Good for savings you might need to dip into now and then, including writing checks.

4. Individual retirement accounts (IRAs)

• What they are: Accounts that help you save for retirement and often come with tax benefits.
• Why use them: Designed for long-term savings.

5. Bonds

• What they are: Bonds are essentially loans you give to governments or companies. They pay you interest, often compounded, over the bond's term.
• Why use them: Great for medium to long-term goals, as they typically offer higher returns than savings accounts while being relatively low risk.

Understanding Compound Interest Periods

Compound interest can be calculated and added to your savings on different intervals. For example, daily compounding adds interest every day, while annual compounding only does it once a year. Other common compounding schedules include semiannually (every six months), quarterly (every three months) and weekly. Generally, the more frequent the compounding schedule, the faster your money grows.

Annual percentage yield (APY)

For a foolproof way to compare accounts or other financial tools that pay interest, look for the annual percentage yield (APY). APY tells you how much you'll earn in a year, based on the interest rate and the compounding frequency. This removes the guesswork when you're trying to compare different offerings.

Pros and Cons of Compound Interest

Compound interest can deliver amazing results when it comes to saving, but it can also work against you when applied to debt. In the same way a nugget of savings can snowball into a sizable nest egg, compound interest charged on debt can quickly balloon out of control—especially since the interest rate on borrowing is usually higher than on savings.

Pros

• Your money grows faster: Interest earns more interest.
• Small savings add up: Even a little bit saved can turn into a lot over time.
• Perfect for long-term goals, like retirement or a big vacation.
• Easily accessible options: High yield savings accounts and CDs make it easy to start.

Cons

• It takes time: You need patience to see big results.
• Not always flexible: Some accounts, like CDs, may lock up your money for a set time.
• Debt grows more quickly: The compounding effect on unpaid credit card balances or other high interest borrowing can lead to unmanageable debt, if you're not careful.

Start Earning Compound Interest Today

Whether you're saving for retirement, an emergency fund or any other financial goal, compound interest can help you get there. To make the most of this powerful tool, look for savings products with high APYs and low or no fees, and be sure to add to your savings regularly. Time will take care of the rest.

LEARN MORE: Which Savings Account is Best for Your Needs?