The Effects of Compounding Interest – How It Works And Why It Matters To Know

Ever wonder how compound interest works? Find out what it is, why it's important to know about it, and what you can do with this financial concept.

People generally know about compound interest but don't understand how powerful and important it is. Compound interest can work for or against you. 

While an easy concept to grasp, compound interest has incredible results. It is the process of earning interest on your initial principal and any accumulated interest. 

We break down how compound interest works and why it matters for those who want their savings to work for them instead of against them.

What is compound interest?

Compound interest is the addition of interest to the principal sum of a loan or deposit so that both the capital and the accrued interest earn interest from then on. The effect of compounding over time can be dramatic. A relatively small amount of money invested with compound interest can grow into a much larger sum due to the power of compounding.

How does compound interest work?

Suppose you have a savings account with a balance of S$12,000 and a bank that pays an annual interest rate of 5%.

The way compound interest works is by earning a return on the principal, which is then added to the total that accrues interest. You will earn 5% (which equals S$600) in interest on your deposit of S$12,000. After a year, you would have a total of S$12,600, which you would then earn 5% interest on, or S$630. This would also be added to the total that earns interest, and so on and so forth. 

In this way, the power of compound interest works to increase the account balance that is earning interest each year even without you adding to the balance. 

Related to this topic: How to get a little richer with the magic of compound interest

Compound interest formula

The compound interest formula is:

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

Where:

• A is the future value of the investment, including both principal and accrued interest
• P is the principal or initial deposit
• n is the number of times that the interest rate is compounded per time period (e.g., year/month/week)
• r is the interest rate
• t is the number of time periods

While it’s handy to understand how the formula works, you do not necessarily need to master it. You can use tools such as online calculators to help you determine how much compound interest your loan or investment will earn.

In essence, the more times your interest compounds, the faster your investment will grow.

Rule of 72 in compound interest

The rule of 72 is a quick way to calculate the number of years required for an investment earning annual compound interest to double. All you have to do is divide 72 by the interest rate, and this will give you the number of years it will take for your money to increase twofold. It’s fairly accurate, especially for interest rates that fall between 6% and 10%. 

For example: if you are earning compound interest at a yearly rate of 6%, then it will take your investment 12 years to double.

Why does compounding matter?

Compound interest is one of the most important concepts in finance because it can have a huge impact on how much money you can earn from your investments. It's also one of the simplest ways to increase your wealth over time!

The more you understand about compound interest, the more you can take advantage of it to grow your money.

Compounding interest and debt: what does it mean?

Compound interest can help your savings grow more rapidly than simple interest, but it might work against you when you're borrowing money.

On average, credit card interest compounds daily on outstanding balances. While the calculation is complicated, the conclusion isn't: when you carry over an unpaid balance to the following month, compounding interest on credit cards increases your debt exponentially.

The often high interest rate and daily compounding are two common reasons for credit card debt repayment difficulties, as well as why you should always try to pay your credit card balance in full each month.

Daily compounding interest is uncommon for various sorts of loans, such as student loans and mortgages. The interest does not compound as long as your monthly payment covers the accrued interest. However, if your payment doesn't cover your interest, you might be in trouble.

For example, if you miss a payment on a car loan or mortgage balance and get hit with late fees or penalty rates, this will cause your outstanding debt to grow more rapidly because of the compounding effect of daily interest. Additionally, the overall loan balance will grow due to negative amortisation, where your total debt increases because of the interest owed.

In short, compounding interest can work for or against you, depending on the situation. In a loan situation, it's important to understand how compound interest will impact your repayment and if you can afford the repayment criteria or not.

How to make sure compound interest works for you and not against you

There are strategies you can use as an individual saver and perhaps even an investor to make sure that compounding works for you.

These include:

Saving early and often

When you save early in your life, you give compound interest more time to work its magic. Even small sums saved on a regular basis can grow substantially over time.

Choosing wisely

Not all investments offer the same compounding opportunities. For example, certain types of bonds may have fixed payments that don't increase with inflation. Variable-rate investments, such as mutual funds or variable annuities, tend to offer the best opportunity for compounded growth. 

Additionally, some banks’ savings accounts charge high account maintenance fees that eat up a substantial amount of your compounded interest over time. So before you choose the bank account for your savings and assets to invest in, make sure that they offer the best opportunities for compound interest.

Diversifying your holdings

A well-diversified investment portfolio will help reduce the risk of causing harm to your overall investment return potential. This includes spreading out your money across different asset categories (such as cash, stocks and bonds) and investing in different countries and companies.

Keeping your borrowing rates low

Whether you're a consumer or business, borrowing money often comes with high interest rates. This can work against your compounding efforts when you have to pay back the principal and interest of that loan on a regular basis.

Try to keep your borrowing rates low, and you'll give compound interest more of a chance to work in your favour. But if you have to borrow, make sure you pay early to avoid any possible compounding fines

Paying your debts quickly and paying extra when possible

Credit card companies compound interest on a daily basis, so it's important to pay off your monthly balance as quickly as possible. You can also save money by paying more than the minimum required each month. This will help reduce the amount of compounding interest you have to pay over the life of your loan.

Reinvesting your earnings

When you earn interest, dividends or capital gains on your investments, don't spend it! Reinvest those earnings back into the investment that generated them. This will allow even more money to work for you and result in accelerated growth over time.

Staying invested for the long haul

Finally, one of the most important factors affecting compounded growth is how long you remain invested. The longer you leave your money working for you, the better off you'll be down the road.

Factors that make compound interest super powerful

There are a few valuable factors that make compound interest so powerful. These factors include:

Deposits and withdrawals

Each time you deposit or withdraw money from your investment, it can have an impact on the compounding process. For example, if you make a withdrawal early in the investment period, there may not be enough time for compound interest to work its magic and increase your earnings. Conversely, if you leave your money invested for a longer period of time, the impact of compound interest will be greater.

Rate of return

The rate of return you earn on your investments also has a significant impact on the power of compounding. The higher the rate, the more quickly your money will grow.

Timeframe

The length of time you have to save, invest and grow your money also has a significant impact on the rate of compounding. The more time you give compound interest to work its magic, the better off you'll be down the road.

Principal deposit

The size of your original deposit (or principal) is also a major factor in the amount of compounded interest you'll earn. The larger your principal, the more money you'll have working for you over time.

There are several factors that can impact the power of compound interest. Understanding these factors will help you make smart investment decisions that can help you reach your financial goals.

Finally, compound interest is a powerful tool that can help you grow your money over time. By understanding how it works and taking advantage of the various factors that affect it, you can make smart choices about where to save and invest your money. With patience and perseverance, compound interest can help you achieve a more secure financial future.

Compounding interest can powerfully shape your financial future. Start investing early in order to reap its full effects; compare online brokerages where you can grow your assets. 

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