Compound Interest – How Does It Work?
- The Frugal Edit
- Jun 1
- 3 min read
Updated: 3 days ago
Beware of little expenses, a small leak will sink a great ship.”
Benjamin Franklin
Compound Interest – How Does It Work?
Compound interest is one of the most powerful forces in personal finance. Whether you're saving money or borrowing it, this post is about compound interest—how it works and how it can have a big impact on your financial future.
We’ll show you how it differs from simple interest*, how it's calculated, and how it applies in real-life scenarios like investing and credit card debt.
What Is Compound Interest?
Compound interest is the interest you earn not only from your original investment (called the principal) but also on the interest* that accumulates over time. In simple terms - You earn interest on your interest.
* Interest is the cost of borrowing money or the reward for saving it, usually expressed as a percentage of the amount.
Why Compound Interest Is Powerful
Time is your ally: The longer you leave your money to grow, the more exponential the effect.
It accelerates growth: Each period’s interest earns interest in the next period.
Compound Interest – How Does It Work vs. Simple Interest
Let's compare:
Example 1: Interest Earned and Taken Out (Simple Interest)
Let’s say:
You invest $1,000
Annual interest rate = 5%
You take out the interest every year
Time = 3 years
Since you withdraw the interest each year, it’s calculated only on the original principal:
Interest per year = $1,000 × 0.05 = $50
Total after 3 years:
You still have your original $1,000
You've collected $150 in interest over 3 years (3 × $50)
Total Value = $1,150
Example 2: Compound Interest (Interest Reinvested)
Same situation:
Invest $1,000
Annual interest rate = 5%
Interest is left in and reinvested
Time = 3 years
Using the compound interest formula Total Value = $1,157.63
Comparison
It might not seem like a big difference now, but remember, the more you invest, the more you stand to earn over time.
Now let’s consider $10,000 at 5% annual compound interest:
As you can see, the total amount increases more each year and could possibly earn as much as $2,275, bringing the total at the end of 5 years to $12,275, the power of compound interest at work!
Formula for Compound Interest:
...For those who would like to test the math themselves, here’s the formula.
A = P (1+ r/n)^nt
Where:
A = the future value of the investment/loan, including interest
P = the principal (initial investment)
r = annual interest rate (as a decimal)
n = number of times interest is compounded per year
t = time in years
Careful with compound interests on credit card debt...
Compound Interest – How Does It Work with your Credit Card and the Interest You Pay
If you carry a balance on a credit card, interest compounds against you, usually daily. This means you’re paying interest on the interest, and your debt can snowball fast.
Example:
You owe $1,000 on a card with 20% APR (Annual Percentage Rate), compounded daily (typical).
Using the same formula, in 1 year, your $1,000 debt becomes $1,221, even with no new charges, just because of daily compounding!
Key Points:
Debt grows faster with compounding, especially at high interest rates.
If you make minimum payments, most of it goes to interest.
You lose money over time unless you pay it off quickly.
Compound Interest – How Does It Work in Real Life: Investments vs. Credit Cards
Investments/Savings:
Compound interest works for you.
The more you save and the longer you leave it, the more you earn.
Example: Retirement accounts, savings accounts, mutual funds.
Credit Cards/Debt:
Compound interest works against you.
Interest compounds daily on unpaid balances.
You pay interest on your interest if you don’t pay in full each month.
A $1,000 balance at 20% APR compounded daily can grow to over $1,220 in one year without new charges.
Conclusion – Compound Interest – How Does It Work
Compound interest can be your greatest ally or a sneaky financial enemy. The key is to understand how it works and use it to your advantage. Save and invest early to let you compound interest grow your wealth. Avoid carrying credit card balances to keep compound interest from piling up against you.
Whether you're saving for the future or managing debt, understanding compound interest is essential for smart financial planning.
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