How does compound interest work?
You earn interest on your interest, so money grows faster the longer it sits.
It works for you on savings, and against you on a debt that is not paid off.
The rule
- With compound interest you earn on your starting balance and on the interest already added. Simple interest applies only to the starting amount. Some term deposits use simple interest.
- The formula is A = P x (1 + r) to the power n, where P is the starting balance and A is the ending balance.
- Worked example: $2,000 at 5% a year, compounded monthly, for 2 years. r is 0.05 / 12 = 0.00416667 and n is 2 x 12 = 24. So A = 2,000 x (1.00416667) to the power 24 = $2,209.88.
- $10,000 at 3% a year compounded monthly becomes $11,616 after 5 years, $13,494 after 10 and $18,208 after 20.
- $10,000 at 5% for 5 years is $12,834 if interest is added monthly and $12,500 if it is added once at the end. The government's money guide puts the average credit card interest rate at over 18%.
What people ask
What is the difference between simple and compound interest?
Simple interest is worked out on the first amount only. Compound interest is worked out on the balance each time, and the balance includes the interest already added. The longer the time, the bigger the gap.
How much will $10,000 be worth in 30 years?
At an assumed 5% a year, compounded monthly, about $44,677. The 5% is an assumption for the sum. It is not a forecast and not a rate anyone is offering.
Does compound interest work against me on a debt?
The same arithmetic applies to any balance where unpaid interest is added to it. Your lender's terms say how often interest is added and at what rate. The government's money guide says the average credit card interest rate is over 18%.
Does it matter how often interest is added?
Yes, a little. On $10,000 at 5% for 5 years, monthly adding gives $334 more than adding once at the end. Daily, monthly and yearly are all used, and your account's terms say which.