Financial advisors share it as a tool. Retirement accounts depend on it. Einstein called it the 8th wonder of the world.
Compound interest is one of the most powerful tools in your financial toolbox. It’s how people grow their wealth—but you don’t need a lot of money to make use of it. With a savings account and an initial deposit, you can start putting compound interest to work for you.
With compound interest, the interest you earn on your savings grows exponentially year after year, allowing you to start with a modest amount and end up with a substantial retirement fund or savings decades later. The key ingredient is time.
Here’s what you need to know to make compound interest work for you.
Compound vs. simple interest
Interest is the money your financial institution pays you to store your money in a savings or retirement account. It’s calculated as a percentage that’s typically paid annually, although in some cases it can be paid quarterly or even monthly, depending on the account.
There are two types of interest: simple and compound. To understand the difference between them, it’s important to differentiate between your principal and your account balance. Your principal is the amount of money you’ve deposited into your account, separate from the interest you’ve earned, while your balance is the total amount of money in your account, including interest.
For example, if you deposited $100 and earned $5 in interest, your principal is $100 while your balance is $105.
Simple interest is calculated based on the principal, or the amount you deposited.
Compound interest is calculated based on your total balance, including interest you’ve already earned.
When choosing the right type of savings account for your needs, make sure you understand what type of interest the account pays. Most savings accounts, certificate of deposits (CDs) and individual retirement accounts (IRAs) earn compound interest, but it’s always best to check.
How compound interest works
What does compound interest look like in action?
Let’s say you deposit $200 into a savings account that pays 5% annual interest. At the end of the first year, you’ll earn $10 in interest, bringing your account balance to $210.
Now here’s where things get interesting.
An account with simple interest will only pay interest on your deposit, or principal, which means you’ll keep earning just $5 each year unless you deposit more funds. An account with compound interest will also pay on the interest you’ve already earned. At the end of year two, you’ll earn 5% of $105, or $5.25. The next year, you’ll earn $5.51. As long as you don’t withdraw any funds, your annual dividend will continue to grow year after year, causing your account balance to build up.
For a more visual explanation of compound interest, check out this video from Investopedia.
How to make compound interest work for you
To take advantage of this powerful financial tool, there are three simple things you need to do:
- Start early. The real magic of compound interest happens over time. The longer you let your money sit, the more your interests—and your balance—will grow.
- Make regular deposits. Adding to your account each month will help boost your interest payments even further.
- Leave the balance untouched. For compound interest to work, you need to make sure the interest gets deposited into your account and added to your balance.
Whether you’re planning for retirement or saving up for your next big purchase, compound interest can help give you a boost. All you need to do is open an account like Remarkable Checking or an IRA and start saving today.