How Compound Interest Really Works

Your elementary school teacher was right; start early and save more.

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Putting money in a bank or credit union means you are paid interest for letting your money sit there, while the financial institution makes a profit by lending that money to others at even higher interest rates. It may seem strange to think of interest as a good thing, but if you are on the receiving end of interest, it is a great thing. When you put money into a savings account, interest goes to work for you. Compound interest can help the money in your savings account grow into a tidy little nest egg.

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What is Compound Interest?

The great thing about compound interest is that you are earning interest on the interest you have already earned. This makes more sense when you compare compound interest to simple interest.

Simple interest is interest that is earned only on the principal. This means that if you had $1,000 and you earned simple interest at a rate of 2 percent a year, each year you would earn $20. Your interest earnings would be $20 the first year, and $20 the second year, and so on. That would never change. At the end of 40 years, you would have $1,800 in your bank account.

Compound interest allows you to earn interest on your interest. If you take that $1,000 an earn 2 percent a year in compound interest, the story changes. At the end of year one, you would have $1,020. For year two, you would earn interest on the entire amount, so you would end up with an extra $20.40, instead of $20. That money would be added to the total, for $1,040.40. If you didn't add any money, letting it sit for 40 years, you would end up with $2,208.04. That's more than $400 more than you would have with simple interest.

Building Your Savings Over Time

Obviously, if you just put $1,000 in an account yielding 2 percent and let it sit for years, your money wouldn't grow very fast. The key is to continue adding money to your savings account regularly so that you have more money to earn interest. The magic of compound interest is that the more you put in, the faster your money grows. Compound interest is also more beneficial the longer you have your money in a savings account, so the earlier you start saving, the better off you are. You can use a compound interest calculator to help you make projections.

If you are 25, and you start with $5,000 in a savings account, and you put in $200 a month for 40 years, your money can grow to $158,904.25 by the time you are 65. If you can up your contribution to $500 a month, you can end up with $380,700.34. If you start five years later, at 30, you only end up with $315,965.65. You miss out on tens of thousands of dollars, just by getting a late start.

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It is important to remember that inflation will erode your real returns. A general savings rule of thumb is that inflation should be figured at between 3 percent and 4 percent a year. This means that your real returns are actually eroded if your account does not have a high yield. When possible, it is a good idea to look for savings products that can offer higher yields, such as online savings accounts, some CDs and other accounts. While you won't find inflation-beating yields right now, in the future, as interest rates rise, and as you automatically add to your savings, you could find that your money begins to grow at a faster pace.

Pinyo is the owner of Moolanomy Personal Finance Blog, it covers a wide range of personal finance and investing topics, with features that include reviews, comparison guides, and Q&A sections.