What Is Compound Interest?

Saving Accounts

Compound interest is the interest paid to people on their savings accounts, investment accounts, and retirement accounts. To better understand the concept of compound interest, let’s take a look at another type of interest—simple interest.

Simple interest is where you get the same amount every year on your initial investment. For example, you invest $5,000 at 7% simple interest. At the end of one year, you would get $350 and, now, you would have $5,350. At the end of the second year, you would get another $350, and would now have $5,700. You would continue to earn $350 a year for as long as you kept the investment.

With compound interest, things work slightly differently. Using the same initial investment of $5,000 at 7% interest, at the end of the first year would also have $5,350. However, compound interest is calculated on the entire amount—the initial investment and any previously paid interest payments. So, at the end of year two, you would get $374.50 and now would have $5,724.50. At the end of year three, you would earn $400.72 in interest and now have $6,125.22.

Initially, for the first few years, there is not much difference in the growth of investments with either type of interest, but compound interest investments are still better. Over time, they will grow significantly faster. In addition, the number of interest payment periods can further help to grow an initial investment.

To illustrate this concept, let’s look at our original example of investing $5,000 at 7% compound interest and how different compounding periods affects your interest earnings.

Length of Investment
1 Year 5 Years 10 Years 20 Years
Annual Compounding  $  5,350.00  $  7,012.76  $    9,835.76  $  19,348.42
Quarterly Compounding  $  5,359.30  $  7,073.89  $  10,007.99  $  20,031.96
Monthly Compounding  $  5,361.45  $  7,088.13  $  10,048.31  $  20,193.69

How to Use Compound Interest to Your Advantage When It Comes to Investing

The best way to take advantage of compound interest and its ability to help grow your savings and investments is to start setting aside money sooner, rather than later. The more time, the greater the return on your money. For instance, using our example amount of $5,000 at 7% compound interest, if you were to invest $800 a month on top of the initial $5,000 for thirty years, at the end of that time you would have just over $1 million.

compound interest

Now, let’s say you only have 20 years to invest using the same amounts; you would only have $439,366.01 at the end of that time. As you can see, your investment more than doubles from year 20 to year 30. If you wanted to retire with $1 million in 20 years, you would need to invest $1,900 a month, compared to $800 a month over 30 years. This is the power of compound interest.

Whether you have ten years or sixty years, start taking advantage of compound interest today by stopping by The People’s Federal Credit Union to open a share savings, retirement, or other investment account today, or call us at 806-359-8571!

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