What Is Compound Interest?

What is Compound Interest? 

Looking to become a millionaire? Perhaps parents, teachers or other well-meaning advisors have given you the advice to “make your money work for you.” But how exactly does someone make their money “work”?

How to Earn Interest

One of the simplest and most painless ways to make your money work for you is by earning interest on money you've already saved. By placing your money with a financial institution, such as in a savings account, certificate of deposit (CD) or money market account, your financial institution pays you an amount of “interest” in exchange for keeping your funds there.

Calculating Compound Interest

Essentially, compounding refers to earning interest on previously earned interest. Compound interest is calculated as a fixed percentage of both your initial deposit (principal) plus any interest earned during the previous compounding period. Then the next time interest is calculated, the larger principal amount (initial deposit + any interest previously accrued) is used. The more times your interest compounds (daily, monthly, quarterly or annual), the more money is added to your principal deposit. Calculate your total compound interest collected over a period of time using our online calculator.

CALCULATOR: How much will my savings be worth?

The Long-Term Effects of Compounding

Compounding gives the greatest benefit to those who save early and often. Even if you're only able to put aside a modest amount each month towards savings, the “snowball” effect of compound interest means your savings continue to grow month-over-month, year-over-year–even if you never contribute another cent past today.

Compare these two savers:

Saver 1 puts $1,000 in their home piggy bank while Saver 2 puts the same amount in an insured account earning 5% Annual Percentage Yield (APY) t compounded monthly. After 5 years, Saver 1 will still have their initial investment of $1,000 while Saver 2 will have $1,283.

Compound interest is a powerful financial tool that allows you to passively earn money by doing nothing other than saving it. This is what it really means to say “make your money work for you” or, more accurately, “make your money do the work for you!” 

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The information above is provided for educational and illustrative purposes only. The accuracy of the calculations and their applicability to your circumstances are not guaranteed.