Finance Definitions: Compound Interest

In fourth grade, a banker came to my classroom to teach my class about compound interest. I was fascinated. First, I was shocked that a bank would pay me money to keep it safe, and second, I loved learning how I could make more money if my interest was compounded.  I memorized every single thing that would be on our compound interest test, and I did really well.  My mom even hung my A+ test on the refrigerator for a few days. 

Then, I promptly forgot everything I learned about compound interest, and as an adult, I needed a review.  I think a lot of people are in the same boat when it comes to financial principals, so let’s review some basics about compound interest:

Test Question #1:  What is compound interest?

Answer:  Compound interest is created when the bank pays you interest on top of your interest.  Basically, when you deposit money, the bank will give you interest every month.  When that interest you earned is added to the principal (the original amount you invested) in your account to calculate the following month’s interest, you reap the rewards of compound interest.  This is compared to simple interest, which is calculated only on the amount you put into the account.

Test Question #2:  How can I make more money from the same amount of money invested?

Answer:  You should invest in an account that compounds more often.  Let’s look at an example of a $10,000 investment at 1%.  If you invest that $10,000 in an account that calculates interest annually, you will make $100 in the course of a year.  If you invest that same $10,000 in an account that pays 1% but compounds monthly, you will make $100.46.  Daily compounding of the same investment details will return a $100.50 in interest. 

An additional 46 or 50 cents may not sound like huge earnings, but over the course of adding money to the account and more continuous compounding, you will start to see a bigger return.  You can play around with your own investment numbers on a compound interest calculator like the one here.

Test Question #3:  Why is compound interest important?

Answer:  In our example above (which is sadly based on fairly realistic numbers for a Certificate of Deposit [CD] these days), the rate at which your money is compounded doesn't seem to make a big difference. However, the longer the interest is being compounded and the higher the interest rates, the more difference the compounding frequency makes.

In the days of high returns (the highest I remember, anyway), money market accounts were returning 5% compounded monthly.  That means that our $10,000 investment if made in the year in 2000 would have reaped the reward of a 5% interest rate compounded continuously. A one year return with compounded interest would have been $512.71 while a simple 5% interest rate would have offered $500. These small changes add up over time. If you're going to make your money work for you, you want it working as efficiently as possible.

Remember that this doesn't apply to just money you invest, but also money you borrow. When you take out any kind of loan, the way in which it is compounded makes a significant difference. Take the time to know the details.

As an adult, I enjoyed reviewing compound interest, and I think I could ace another test.  As you review basic banking principals with us at MomVesting.com, we hope you will begin to ace your own financial tests and invest wisely in your future.

Photo by tsuacctnt via flickr creative commons