What is compound interest?
Editorial staff, J.P. Morgan Wealth Management
- Compound interest is, very simply, the interest you earn on interest.
- Over time, compound interest grows your money exponentially. The longer you leave it to grow, the more you can potentially earn over time.
- Investments that offer compound interest include bonds, certificates of deposit (CDs), money market accounts, high-yield savings accounts and other investments.
- Investing in stocks may provide the power of compounding, but it’s not the same as what happens with compound interest investment products.
What is compound interest?
Compound interest is an investor’s best friend – or one of them, at least. Essentially, it refers to the interest you earn on interest. It can also apply to debt – like credit card debt – but for the purposes of this article, we are going to focus on investments.
Rather than simply earning interest on the money you invest, accounts that have compound interest allow you to earn interest on the money you invest and on any interest that’s already accrued. Over time, this creates the potential for much higher growth.
Here’s a closer look at compound interest and how investors can use it to their advantage.
What is simple interest vs. compound interest?
To understand compound interest, it’s important to first understand what interest is: the money added to your investment based on the investment’s rate of return. This can be variable, like with a high-yield savings account. Or it can be fixed, like with a certificate of deposit (CD) account.
Generally, there are two types of interest: simple and compound. Simple interest is based on the principal balance of an investment – or the money you initially put into it. Compound interest, on the other hand, is based on the principal balance as well as interest you earn on that balance over time. Depending on how often the interest compounds, you can potentially grow much larger returns this way.
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How does compound interest work?
With compound interest, every time interest is paid to your account, the amount is calculated based on the principal balance and any interest that was added on previously. So if you had deposited $250 into an account and earned $5 in interest, the next time interest is paid, it would be based on the full $255. This way, the interest you earn can steadily increase over time even without additional contributions.
Here’s another example that involves compound interest’s best ally: time.
Let’s say you put $5,000 into an account with a 5% annual interest rate, compounding daily. If you leave that money invested for a significant period, it will grow more substantially. After 35 years, your balance would be $28,770. With simple interest, though, you balance would only be $13,750. There you have it: the benefits of compound interest.
How is compound interest calculated?
While it’s easier to use a compound interest calculator, you can calculate it on your own by using the following compound interest formula:
A = P (1 + [r ∕ n])nt
- A = the amount of money accumulated after n years, including interest
- P = the principal amount (your initial deposit)
- r = the annual interest rate (as a decimal)
- n = the compounding frequency (daily, monthly or annually)
- t = the number of years (time) the amount is deposited for
Let’s walk through an example. Suppose you invest $10,000 into a savings account at 5% interest, compounding monthly for 15 years. In this example, P = ($10,000), r = (.05), n = (12) and t = (15). Now, plug those numbers into the compound interest formula.
- A = P (1 + [r ∕ n])nt
- A = 10,000 (1 + [.05 ∕ 12])(12 × 15)
- A = 10,000 (0.00417)(180)
- A = 10,000 (2.1137)
- A = 21,137
As a result, in 15 years, you would have $21,137 in your savings account. Breaking it down, this would include the initial $10,000 deposit and $11,137 earned in interest.
What investments have compound interest?
There is a range of investment types that offer the power of compound interest, including:
- Money market accounts: Money market accounts can significantly enhance earning potential because they calculate returns not just on your initial deposit, but also on the interest you’ve already accrued. These accounts typically compound interest daily and credit it monthly. In turn, each day’s interest becomes part of tomorrow’s earning base.
- Certificates of deposit (CDs) and high-yield savings accounts: As you deposit funds into accounts that earn interest, the interest is credited to your account, increasing your balance over time.
- Bonds: Zero-coupon bonds are sold at a discount and don’t pay out interest until they mature. Instead of regular payments, the interest compounds over time, potentially yielding more substantial growth for investors.
While stocks don’t offer compound interest per the official definition, they do provide the power of compounding. The compounding effect in stocks can occur when you reinvest dividends to buy more shares of a stock, which can earn you additional dividends. It also can occur when you investment grows through price appreciation over time, providing a larger base for future percentage gains.
What are the benefits of compound interest?
With compound interest, your money works harder for you by earning returns not just on the initial amount, but also on the interest you've already earned. Over time, this cumulative effect can lead to significant growth, especially compared to simple interest.
Beyond that, here are some of the other benefits of compound interest to consider:
Offers passive income generation
Compound interest in a diversified portfolio can create a reliable income stream, which can help investors save for long-term financial goals like preparing for retirement. Beginning your investment journey early can help you build substantial earnings through passive income.
Mitigates risk factors
Because compounded interest can yield exponential growth, it can help investors mitigate financial risks, like inflation and market volatility. Choosing investments that can potentially outpace inflation and maintaining a diverse portfolio can yield strong returns, thereby helping investors sustain long-term financial stability.
How can investors best take advantage of compound interest?
Compound interest works best when it has the time to compound. As seen in the examples above, when you leave your money in a compound interest account for decades, it grows exponentially larger than if you were to leave it for just a few years. As such, investors working with compound interest should have a long-term mindset.
The bottom line
Investors may want to take advantage of compound interest accounts as a part of their diversified investment strategy. If you are unsure of what may or may not make sense for your individual situation, consider working with a financial advisor who may be able to offer a customized approach.
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Editorial staff, J.P. Morgan Wealth Management
