The Amazing Power of Compound Interest

One of the most constructive, and destructive, forces in finances is the power of compound interest. Compound interest is interest that is not only paid on the principal, but also on the interest that previously accrued on your investment. On the other hand, compound interest can work against you — for instance, as finance charges against your credit card debt that could quickly snowball out of control. It can be a great burden, or a great boon. It all depends on the money choices you make.

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Making Compound Interest Work for You

Compound interest can be a great gift to you if you avoid debt and get into the habit of saving your money. A high yield savings account can get you a 1.35% annual yield, but if you look into longer term certificates of deposit, you can get around 3.00%. And if you invest for the long-term in diversified investments, you can expect an even higher average annual returns.

When you put money into interest bearing accounts, or dividend yielding investments, you get paid for letting your money sit there. For example, if you have $1,000 and average 4.00% APY across your savings and investments, after a year, you’ll earn $40 in interest and dividend. If you let your money sit in your savings account and reinvest the dividend, the following year you will earn $41.60 — doesn’t sound like much, but your original $1,000 will turn into $1,423.31 after 10 years, $2,106.85 after 20, and $3,118.65 after 30!

Tips for helping compound interest work for you:

  • Start immediately to save and invest your money. The earlier you start, the more you will earn as compound interest works on your behalf. How much you start with isn’t as important as getting started.
  • Let the money sit. This is easiest in a retirement account. Simply leave the money alone. It will gradually build up on itself as the interest you earn is added to the principal amount you invested — and then interest is earned on the new total.
  • Add to your account regularly. While compound interest works well, you can multiply the power of compound interest by making regular additions to your interest bearing accounts.

Compound Interest Can Work Against You

One of the most destructive examples of how compound interest can work against you is credit card debt. Every month your interest charges are added up and then tacked on to the balance. Pretty soon, you are paying interest on your interest and barely reducing the principal at all — especially, if you only pay the minimum. In fact, it is possible to pay back many times what you originally borrowed when you are only paying the minimum.

Other loans charge compound interest as well, but credit card debt is the most devious. It can also be one of the most difficult to get out of, since the interest rates charged are so high, and in some cases the interest is compounded daily.

Consider your financial choices carefully. You want to be making compound interest work for you, rather than working against you.

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About the Author

By , on Apr 15, 2010
Andy Tenton
Andy is a 30-something New Yorker who turned his financial life around. He took charge of his finances, got out of debt, and is now working his way toward financial success. He is the owner and publisher of WorkSaveLive.com.

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Leave Your Comment (3 Comments)

  1. Tom says:

    Andy, Good overview. I would love to see you expand this article with some additional examples (saving 2%, 5%, 10%) of your income, paying yourself first, etc.

  2. Alex says:

    Good basic description of compound interest and how it can work for and against you. To really attract people to start saving early, i would go with an example of saving say 10% of your paycheck every time, over 20 years, with the compounded interest. It is really amazing to look at what can happen if you start saving early, and keep saving. remember that the 10% gets higher as you get promotions and raises over your entire career.

    One of the most interesting savings strategy’s i have been introduced to is to act like you smoke cigarretes. save 1 packs worth of money every other day or however much you can afford over your lifetime and watch the numbers rise on a spreadsheet.

  3. Spivey says:

    Andy, Good Overview. Compound interest is one of the most important concepts when trying to develop financial freedom. You had a good example in the second section showing how your money can grow using it. If you ever re-post this article you may consider showing an example where you continue to add to the investment as well as the involvement of compound interest, then contrast the two.

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