What Is Compound Interest?

One of the most important concepts to grasp when you are thinking of saving and investing and why it is such a worthwhile activity is the concept of compound interest. The power of compounding is considerable and can take a tiny nest egg to a sizeable sum over time.

The definition of compound interest  is “the interest paid on capital and any previously accrued interest.” But how, exactly, does it work? The best way to explain compound interest is with an example. Let’s say you have decided to open a savings account. The account earns compound interest. This means that once you deposit the initial amount, it will earn interest on that amount over a certain period of time such as a month, or a year. At the end of that time period, the interest earned is then added to the initial amount you deposited, and then interest is earned on the new total over the next period, and so on and so forth. That is why it is called compound interest – since the new amount is compounded, or combined with the old amount to get a new total figure.

The idea is that if you can leave your savings alone for a long enough period of time, the compounding will cause the initial sum to grow exponentially. If you are not certain what that means, let’s just say it means “by a lot!”

A Real Money Example
Some people like to see the power of compound interest at work on real examples of money – this allows them to get a much more clear idea of what is happening.

Let’s say you have $1,000 to put aside in a savings account that earns 5 per cent every year. Let’s also say the interest accrues on a quarterly basis. What that means is that a portion of the 5 per cent is paid out every three months. So, every quarter, 1.25 per cent of interest is paid out and is then compounded and another 1.25 per cent will accrue on the new total during the next quarter.

To Illustrate:
Initial Deposit: $1,000
First Quarter Interest = $1,000 x 1.25% = $12.50
Add that to get the new amount = $1,000 + $12.50 = $1,012.50
Second Quarter Interest = $1,012.50 x 1.25% = $12.66 (see, the interest is higher!)
Add that to get the new amount = $1,012.50 + $12.66 = $1,025.16
And so on …
Third Quarter Interest = $1,025.16 x 1.25% = $12.81
Fourth Quarter Interest = $1,037.97 x 1.25% = $12.97

The important thing to keep in mind is that compounding interest over a smaller time periods is better than longer time periods. For example, in the above example, from the initial $1,000 investment, the total interest earned over the four quarters was: $12.50 + $12.66 + $12.81 + $12.97 = $50.97.

However, if the interest only compounded annually – the total interest for the year would be just $50.00. While that $0.97 difference does not seem like a lot of money, the difference over a period of many years and different starting amounts is considerable. So whenever possible, if you are looking to open a savings account, check to see when the compounding takes place. Quarterly is better than annually, monthly is better than quarterly, etc.

Where Do I Get Compound Interest?
As you can see, compounding interest can work in your favor to grow your savings leaps and bounds. But you might be wondering how you can take advantage of it. Check with your local bank – they may have savings accounts that earn compound interest. Keep in mind that not all accounts will earn the 5 per cent used in our example. The rates could be higher or lower depending on the general economic environment at the time. Also, some savings accounts will earn higher interest rates but you may have to leave your money in the account and not have access to it for longer periods of time – so just be sure you understand all the account rules when you open it!

Tuesday, March 30th, 2010 financial Info

No comments yet.

Leave a comment