How Does Compounding Interest Work?
Compounding interest can pay off when used the right way.
Contributing Writer at Tally
April 23, 2021
If you're wondering, “How does compound interest work?” you're far from the only person. It may sound confusing, but except for its complex formula, it's relatively easy to explain how compound interest works.
Adding to the confusion is that compound interest can be both a good thing and a bad thing.
We'll help lift the veil of confusion on compound interest by explaining what compound interest is, how it works, when it's good, when it's bad and how to avoid the bad compound interest altogether.
How Does Compound Interest Work?
Compound interest is when interest charged or earned is calculated using previously accumulated interest.
For example, if you had a $1,000 balance in a high-yield savings account that paid a 1% annual percentage yield (APY), you'd earn $10 in interest, bringing your principal balance to $1,010.
The 1% APY would apply to the full $1,010 balance in the following year, so your annual return would be $10.10 in interest, bringing the balance to $1,020.10. The 10 cents is your compound interest, and this compounding repeats and grows year after year.
You can manually calculate compound interest with the compound interest formula: P(1 + (R/N))^(N x T).
P = Initial principal balance.
R = Interest rate.
N = Number of time periods elapsed per time period.
T = Number of time periods elapsed.
If that's too much for you to compute, countless online compound interest calculators take care of calculating compound interest for you.
Simplified, compounding is interest on interest.
How Compound Interest Differs From Simple Interest
Compound interest isn't the only way the financial industry calculates interest. There is also simple interest.
While compound interest works by paying or charging interest on interest, simple interest works by paying or charging interest only on the original principal balance.
Using the same example of $1,000 in a savings account at 1% APY, but switching to a simple interest model, here's how the earned interest would differ. In the first year, you'd still earn $10 in interest, bringing the balance to $1,010. In year two though, you'd earn the 1% interest on only the initial deposit — the original $1,000 principal balance — bringing the total balance to $1,020.
So, with compounding interest, you'd earn an extra 10 cents in interest payments in year two. This gap in earnings would grow as the years progress.
What Is the Rule of 72?
When speaking about compounding interest, the rule of 72 is sure to come up. While not a precise calculation, the rule of 72 can give you a rough estimate of the number of years it'll take to double your initial investment through compound interest.
The rule of 72 formula is simple: 72 divided by the interest rate equals the period of time for your investment to double.
For example, if you have a $100,000 investment that earns 5% interest, the calculation would be 72 divided by 5 = 14.4 years. So, in approximately 14 years and five months, your investment should be worth $200,000.
How Can Compounding Interest Be Good and Bad?
Compound interest can work for or against you, as it can help your cash grow exponentially, but it can also end up costing you big in the case of credit card debt.
When compounding interest is a good thing
Compounding interest is helpful in any account that pays you interest because you will earn interest on the interest earned in the previous period.
For example, if you have a 401(k) account with a $100,000 balance one year that earned 10% interest, your principal balance would be $110,000. If that 401(k) earned the same 10% rate of return in the second year, it would apply to the full $110,000 balance, not just the initial investment, earning you $11,000 in interest.
With the power of compounding interest and the exponential growth it delivers, you'd have a total amount of $2.8 million in your 401(k) in 35 years at this pace. This is with no additional deposits — just letting annual compounding do the work.
Accounts where compounding interest will work for you include:
Interest-bearing checking accounts.
Stocks and bonds.
Money market accounts.
When compounding interest is a bad thing
While that $2.8 million 401(k) balance puts a silver lining on compounding interest, there is a downside to it. This is when lenders charge compound interest on your balances. Credit cards are a prime example of compounding interest being a bad thing.
Let's say you charge $1,000 on your credit card, which has a 19% annual percentage rate (APR) — the annual interest rate the card charges — and your minimum payment is 4% of the balance. If you choose to make only the minimum payment, the first month's payment would be $40, bringing the balance to $960, but the credit card company adds $15.83 in interest. This puts your new balance at $975.83.
The following month, the credit card company bases the minimum payment and interest charges on the $975.83 balance, not the $960 principal amount. This means it's charging you interest on the $15.83 in interest from the previous month.
In this new month, your minimum payment would be $39.03, but the credit card company will add $15.45 in interest charges. The balance after making the minimum payment and adding the interest would be $952.25.
So, over two months, you've made $79.03 in monthly payments but only reduced the balance by $47.75. That's the power of compounding interest in reverse.
Avoiding credit cards’ compounding interest
Credit cards' compounding interest may make you think you have to cut up all your cards and throw them out. But you can still use your credit cards and enjoy their perks without paying a penny of interest.
The secret is to only charge as much as you can afford to pay in full every month. Suppose you pay your whole credit card balance off in full by the due date. In that case, you are still within the interest grace period, so the credit card issuer won’t apply interest to your account.
You will still receive all your rewards points and other perks, but without the interest charges.
How Can Compounding Interest Make or Break Personal Finances?
When applied to an aggressive investment plan, the advantage of compound interest is it allows you to build wealth quickly and reach financial freedom.
For example, let’s say you're 23 years old with a job that offers a 401(k), and you deposit $19,500 per year into the 401(k) until you're 67. If you earn a conservative 7% interest, you'd have $5.7 million in retirement savings. Talk about financial freedom.
You could even retire at age 55 with a $2.3 million 401(k) account balance at that pace and enjoy your younger years.
When applied to credit card debt, the opposite is true. With the power of compound interest in the credit card issuer's hand, it can turn that $1,000 credit card balance into seven years of payments totaling over $1,500.
As your credit card debt grows, the compounding interest also grows, which can make it difficult to reach your financial goals.
Compounding Interest: The Good and Bad
Determining whether compounding interest is good and bad depends on who’s wielding the power. For an investor, compounding interest is what builds their wealth. However, for someone in credit card debt, compounding interest is what keeps them from digging out.
With the right planning, financial management and execution, you can use compounding interest to grow your wealth and reach financial freedom.
If you find yourself in credit card debt, Tally can help. With the Tally line of credit1, which generally has a lower interest rate than a credit card, you can pay off your high-interest debts and stop the compounding cycle. What's more, Tally can also manage all your credit cards, so you never miss a due date and receive a late charge.
1To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) Will be between 7.9% - 25.9% per year, and will be based on your credit history. The APR will vary with the market based on the Prime Rate.