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What is compound interest on savings and investments?
What is compound interest on savings and investments?
Compound interest is the interest earned on an investment, added to the balance, allowing the increased balance to generate additional interest in the next period. To simplify, it is the concept of earning interest on interest. It is what allows investments to grow exponentially over time rather than linearly.
This page will break down how compound interest works when saving and investing, and how relatively small contributions can turn into significant wealth when starting early.
Key Terms
Key Terms
Principal β The original amount of money invested before interest is earned. Interest is calculated based on the principal amount.
Interest Rate β The percentage of the principal amount that will be earned. It is typically considered to be annual, but this distinction is important when comparing opportunities.
Compounding Period β How often interest is added to the balance. Interest may be compounded daily, monthly, annually, or at any other interval decided by the lender or investment provider.
Time Horizon β The amount of time an investment will be held before it is withdrawn.
How Compound Interest is Calculated
How Compound Interest is Calculated
The future value of a lump-sum contribution saved or invested can be calculated using this compound interest formula:
The future value of recurring contributions saved or invested can be calculated using this compound interest formula:
How to Maximize the Benefit of Compound Interest
How to Maximize the Benefit of Compound Interest
The interest rate you can reasonably expect to receive is based on current market conditions.Β
For our use case we will use an 8% annual return, which is close to the historical average for the U.S. stock market over the past 150 years.
The time horizon of an investment depends on when you start investing and when you plan to access the money. If retirement is a goal, the time horizon only shortens the longer you wait to begin. You have direct control over their personal contributions. Due to the exponential nature of compounding, contributions are significantly less impactful than the time horizon and interest rate. To illustrate the power of time we will review a few potential investment scenarios:
As shown by Scenario 1, twelve years of early contributions outperform thirty-six years of later contributions (Scenario 2) simply because the investment had a longer time horizon to compound.Β
Scenario 3 demonstrates that while increasing contributions to catch up is possible, it is much less efficient.
The investor contributed six times as much as in Scenario 1 but only generated an additional $40,484 in interest.
Scenario 4 demonstrates the optimal approach to generating wealth through compound interest. By starting early and remaining consistent throughout the entire time horizon, they contributed less than Scenario 3 but generated an additional $459,911 in interest.
By earning interest on interest over long periods of time, small contributions turn into significant wealth.Β
To maximize the benefits of compound interest, U.S. adults need to understand how principal, interest rates, compounding periods, and time horizon interact.Β
This understanding will allow U.S. adults to make informed decisions about when they should begin investing and how much they should contribute to achieve their wealth-building goals.
What's next?
What's next?
Now that you understand what compound interest can do for you, you are ready to to use it to achieve your financial goals.
Continue on to Investment Accounts and Strategies to learn about common account types and investment strategies.
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