Compounding is often described as “interest earned on interest,” and can help grow investors’ money quicker.
But you’ve got to understand compounding to really be able to take advantage of it. Let’s take a closer look.
What is compounding?
Your money compounds when you earn interest or returns on money that’s already earned interest or returns.
Think of it like a snowball rolling down a hill. The snowball starts small, but as it keeps rolling, its momentum builds and it grows bigger and bigger.
Take a savings account, for example. When you have money in a savings account that earns interest, you receive interest on the amount you deposit and the interest you earned from the previous period.
The term "compound interest" is usually used for accounts that pay a set, guaranteed interest rate (like a savings account). Money that’s invested can compound, too. Technically, your investments can earn “compound returns,” because investments don’t always grow and you don’t earn a set interest rate from them. But many people use the terms “compound interest” and “compound returns” interchangeably.
For both savings and investment accounts, compound interest can work in your favor. Take a long-term approach and stay the course, and you have a better chance of your money growing over time.
How does compound interest work?
Compounding can be confusing, so here’s an example.
Suppose you open an investment account with an initial deposit of $100, and you earn a hypothetical, conservative 7% annual return.
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Year 1: After one year, you’d have a balance of $107: your original $100 plus $7 in gains.
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Year 2: You leave your $107 invested, and a year later, you notice you have more than expected. Your balance is now $114.50.
So what happened? Since your investment was compounding, your returns in year 2 were calculated using your new year 1 total of $107. You earned another 7% in year 2 — or $107 plus $7.50 in returns.
Extend this example a few years or even decades out, and your balance will likely be higher. In 10 years, with markets growing at the same annual rate of 7%, you’d have about $197, or almost 50% more than your initial investment, without having invested any more money!
It’s also important to know compound interest can also work against you. For example, when you don’t pay off your credit card in full each month, the issuer charges you daily interest on your unpaid balance and unpaid interest. In other words, more interest is added on top of what you already owe.
How to calculate compound interest
Before you break out your TI-83, here’s a look at the formula for calculating compound interest and returns.
Compound Interest Formula
A = P(1 + r/n)nt
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P is your initial principal or investment. This is the amount you start investing or saving with.
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r is the interest rate or returns you expect to receive. History shows that major market indices (like the S&P 500) typically return 7% annually. Remember, this is an average, so some years have higher gains and some have bigger losses.
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n is the number of times interest is compounded per year. The most common compounding periods are daily, monthly, and annually.
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t is the length of time you plan to borrow, invest, or save. Long-term investors should try to think about this variable in decades, rather than months or years.
Hopefully, this formula doesn’t give you nightmares of high school algebra, but if it does, there are easier ways to calculate compound interest, especially for investors.
How to use this compound interest calculator
This compound interest calculator can help you calculate your potential returns. Try out different numbers to see how much your investment could change over time. Many of the input fields should remind you of the compound interest formula above
Initial deposit: This is your investment on Day 1, or how much you’ll be starting with.
Contributions: If you plan on investing on an ongoing basis, you can enter an ongoing contribution amount. This way, you can see how using a consistent investment strategy (or dollar-cost averaging) could impact your investment’s potential growth.
Contribution frequency: Since every investor is different, you can pick how frequently or infrequently you plan to make those contributions. Maybe it’s one dollar a day from your Acorns Round-Ups®, or maybe you like the idea of investing $100 at the end of each month with a Recurring Investment.
Average annual return: This is the percentage you expect your investments to grow each year. When you’re investing, it’s unlikely you’ll get a steady return of 7%, or any other amount — the stock market can go up and down daily and even yearly.
But history shows that the U.S. stock market has always grown over time, so this annual return represents how you expect your investments to grow on average and over the long term, not every single year. A 7% return is an estimate based on the growth of the general market over the last hundred years, but more conservative investors may consider reducing this.
Years to grow: This is your investment horizon, or how long you plan to leave your money invested.
The Rule of 72
Another way to quickly calculate potential compound interest is with the Rule of 72. The Rule of 72 is a quick formula for estimating how long it would take to double your investment.
Divide 72 by your expected annual rate of return and the result is the years you’ll have to wait before your investment doubles.
For example, if you expect to earn an average annual return of 7%, you’d have to wait a little over 8 years before your $100 becomes $200.
Don’t let this napkin math guide your investment strategy, but as a launching pad, the Rule of 72 can be helpful.
How to take advantage of compounding
Compound interest can be a force that propels your investments further — here are three ways that might help you take advantage of it.
1. Invest early
More time in the market translates into more time for your money to potentially compound, if the markets rise. If you can, start investing as soon as possible — even small amounts can add up over time.
2. Invest often
By making consistent investments, you give your money a chance to take advantage of potential dips in the market. Over time, those small nibbles can turn into big bites.
3. Stay diversified
There’s a reason most experts advise against putting all your eggs in one basket. A diversified portfolio holding multiple types of investments (such as stocks or bonds) gives your investing portfolio a shot of weathering the storm in bad times and can help set you up for success in the long term.
Getting started is simple. Open an Acorns Invest account to access a diversified portfolio that matches your personal circumstances and financial goals. With Acorns, you can also set up Recurring Investments — an easy way to make periodic investments that could help you take advantage of compound interest over time.
