Compound interest explained

If you’re looking to grow your savings or investments over time, it's important to understand compound interest. This powerful financial tool allows your money to grow exponentially over time, significantly boosting your wealth. But what exactly is compounding? In this guide, we’ll explain the basics, demonstrate how it works, show you how to calculate it and provide examples to enhance your understanding.

What is compound interest?

Compound interest is the interest calculated on both your initial deposit and the accumulated interest from previous periods. This means your savings grow faster over time as you earn interest on an increasingly larger amount. It’s a powerful way to boost your savings and build wealth.

How does compound interest work? 

Compound interest works like the snowball effect. You start with some money in a savings account, and in the first year, you earn interest on that money. In the following years, you earn interest on both your original money and the interest you’ve already earned. The key is time. The longer you leave your money in the account, the more interest you earn, and the bigger your savings grow. 

Discover more about how interest works in general in our comprehensive guide.

How to calculate compound interest

You can use the following formula to calculate compound interest: A = P ( 1 + r/n ) nt. Let’s break this down: 

• A: The total amount after compound interest
• P: The original balance (or principal)
• R/N: The interest rate (as a decimal) divided by the number of times interest compounds per year
• NT: The time (years) in which interest is building

To estimate how long it will take to double your money, you can use the Rule of 72. Simply divide 72 by your annual interest rate. For example, with an interest rate of 1.5%, you would divide 72 by 1.5, resulting in approximately 48 years to double your investment.

Investment compounding

Investing in bonds and bond funds can also yield compound interest. Essentially, a bond is a loan you give to a company or government, which they repay with interest, typically on an annual basis. Similar to savings, if you reinvest the interest earned from bonds over the years, you will earn interest on your interest, known as compound interest.

Many companies distribute dividends quarterly or semi-annually instead of annually. This allows compounding to take effect more quickly, enabling you to earn interest on your interest sooner.

Learn more about investing in bonds with our beginner’s guide to investing.

The benefits of compounding

Compound interest offers several key benefits, including:

• Accelerated growth: Your investment grows at an increasing rate over time because you earn interest on the accumulated interest from previous periods.
• Long-term returns: Compounding can offer significant long-term returns on your initial investment. The longer you let your money sit, the more it grows, as each year, you earn interest on an increasingly larger amount.
• Encourages long-term financial planning: By putting your money into a savings account and letting it grow with compound interest, you’re motivated to save and grow your money with your financial goals in mind.
• Combatting inflation: Inflation can hurt your money’s purchasing power. However, the power of compounding works against inflation. By earning interest on both your initial deposit and the accumulated interest, your money can grow at a rate that keeps up with or even surpasses inflation.