What Is Compound Interest and How Does It Work?

Without interest, your money doesn’t grow.

If you keep cash in a shoe box at home for a rainy day, your total won’t increase unless you add more to it.

On the other hand, if you borrow $50 from your sister, the amount you owe doesn’t inflate to $75 when it’s time to pay her back because it’s a no-interest loan. (Thanks, sis.)

But if you were to keep your savings in a bank account or take a loan from a payday lender, the outcome would be different. You’d see an increase to your savings — or what you owe — due to compound interest.

But what is compound interest, and how does it work? We’ll explain.

What Is Compound Interest?

Compound interest is a basic financial concept that explains how your money can grow exponentially. Your balance increases by earning interest on the interest.

A bit confusing, we know. So let’s break it down with an example.

If you had $1,000 in an account earning 5% interest on an annual basis, you’d end up with $1,050 at the end of the year. If your interest is compounded, you’d earn 5% of your $1,050 balance — an additional $52.50 — by the end of the second year, leaving you with a total of $1,102.50.

Simple interest, on the other hand, is interest on only the original balance. Your interest earnings aren’t factored in when calculating interest in subsequent years.

If your $1,000 were in an account earning simple interest at the same 5% annual rate, you’d still have $1,050 at the end of the first year. However, at the end of year two, you’d only earn interest based on the $1,000 you initially deposited, not on the $1,050. You’d earn another $50 instead of $52.50, leaving you with a balance of $1,100.

Now, an extra $2.50 is far from a big deal, but let’s say you left that money in your account for 20 years instead of two. With compounding interest, you’d have $2,653.30 at the end of 20 years. With simple interest, you ‘d have only $2,000.

How to Calculate Compound…