What Is Compound Interest And How Can It Make You Wealthier?

Saving for a big goal like retirement can feel overwhelming. With tight budgets and plenty of time to kick the can down the proverbial road, saving for the future has become an afterthought for many.

But with Social Security income that typically only replaces about 40% of preretirement income and private-sector pensions quickly fading out of existence, more Americans are having to grapple with the reality that they’ll need to save for retirement on their own.

Feeling stressed at the prospect of saving for retirement or your other long-term goals? We have good news: You don’t have to put away tons of money each month to reach your savings goals. You just have to start now and take advantage of a concept known as compound interest. Understanding what compound interest is can make planning for retirement a little bit less stressful.

What Is Compound Interest?

Compound interest is calculated at a specific frequency, such as daily or monthly, then added back to the principal (your initial investment) so the next interest calculation includes the now-larger principal. This results in exponential growth of the investment balance.

You may have heard that when it comes to saving for retirement, the sooner you start, the better. That’s true, and not just because you’ll have more time to put money away if you start early in your career. The sooner you start putting aside money for retirement, the longer your money has to grow from compounding interest.

But while we often talk about compound interest in the context of retirement, it also applies If you are working your way toward saving for larger purchases or investments, such as a car or mortgage down payment. Making regular contributions (and starting as soon as possible) can help your savings grow through the power of compound interest.

How Does Compound Interest Work?

The amount of compound interest that you'll earn depends on a number of factors, including the principal amount and annual interest rate. The compounding frequency is another factor in the rate of return.

The Rule Of 72

The Rule of 72 is one simple method for getting a quick sense of the return on compound interest. This rule says that the annual interest rate of an investment multiplied by the number of the years it takes for the investment to double equals 72. So if you have an investment returning 8% per year, it will take around 9 years to double your money (because 8 times 9 equals 72). If you only earn 6%, it will take 12 years for your investment to double.

The Compound Interest Formula

But if you’re a fan of doing the math yourself or want to get a more accurate number than the Rule of 72 can provide, here’s an equation you can use to calculate compound interest on your own.

A = P * (1 + r/n)^nt

• P = the initial amount or principal
• r = the annual interest rate
• n = the number of times per year that the interest is compounded
• t = the number of years you hold the investment
• A = the final value of your investment

Example: How To Calculate Compound Interest

Here's an example of how you can use the compound interest formula to calculate an expected return. Let's say that you put $10,000 in a 10-year certificate of deposit (CD) earning 5% annually. Your CD compounds interest daily, so n = 365. Plugging these numbers into the formula above gives you the following return values:

A = $10,000 * (1 + (5%/365))^(365*10) = 10 year total

• After 1 year, you have $10,512.67
• After 2 years, you will have $11,061.53
• And at the end of the 10-year period, your initial $10,000 investment will be worth $16,486.65

Simple Interest Vs. Compound Interest

It's important to understand the difference between simple interest and compound interest — simple interest is just the total principal amount multiplied by the interest rate. With compound interest, the interest you earn ALSO earns interest. This compounding can truly supercharge your returns.

In the example above, a $10,000 CD earning 5% in simple interest would only be worth $15,000 at the end of 10 years. The additional $1,486.65 in returns is due to compound interest.

How To Make Compound Interest Work For You

Now that you're aware of what compound interest is and why it's important, here's a few ways that you can make compound interest work for you:

Research Compounding Interest Account Options

There are many different options that can earn interest, so it is usually best to compare annual percentage yields (APYs) and compounding schedules. CDs, savings accounts and money market accounts are among the types of options that offer compound interest. There may also potentially be minimum account balances or fees, so be careful to meet the required balance.

Start Saving

One of the best things about compound interest is that there is no minimum amount that you need to contribute to earn it. Even small amounts of money saved can earn compound interest, though some types of accounts may have minimum balance requirements. And of course, the more money you invest, the more money you'll earn through compound interest.

Monitor Your Balance

For some people, monitoring money savings and accrued interest over time can be a motivating factor. Seeing your balance grow can help encourage you to regularly contribute and grow your account. Using an app like Rocket Money℠ that helps track the balances of your financial accounts can be a smart financial move.

The Bottom Line: The Power Of Compound Interest Can Make Your Money Grow

Compound interest has been described as the "eighth wonder of the world," and it is one of the most powerful forces in all of finance. Compound interest differs from simple interest in that the interest that you earn also earns interest. This allows your money to grow at an even faster rate. You can take advantage of compound interest by researching high-yield options, regularly saving your money and monitoring your balance.

If you're ready to make compound interest work for you, download the Rocket Money app today to monitor your balances and watch them grow.