What is compound interest?

Compound interest builds your money at an accelerated rate. It's interest on top of interest: Your deposits pile up interest, and the interest piles up interest, too!

This can lead to incredible growth over time.

In contrast, simple interest amounts to interest on only the intial principal year-by-year. Previous interest is not taken into account.

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Compound interest vs. simple interest

Let's say you deposit $20,000 into a high-yield savings account that compounds interest at 3.25%. Over the next five years, your account could grow to over $23,000.

Compound interest over 5 years at 3.25%

Year Initial Balance Interest Gained Final Balance
1 $20,000 $650 $20650
2 $20,650 $671 $21,321
3 $21,321 $693 $22,014
4 $22,014 $715 $22,730
5 $22,730 $739 $23,468

Simple interest over 5 years at 3.25%

Now let's see what the same amount would look like with simple interest at the same rate, over the same period, for comparison's sake.

Year Initial Balance Interest Gained Final Balance
1 $20,000 $650 $20650
2 $20,650 $650 $21,300
3 $21,300 $650 $21,950
4 $21,950 $650 $22,600
5 $22,600 $650 $23,250

The difference between the $23,468 with compound interest doesn't seem like that much more than $23,250, with simple interest. But flash forward to the end of 23 years under this scenario.

With compound interest, you will have more than doubled your initial investment to $41,735, while with simple interest you're looking at just $34,950. At the end of the 50th year, compound interest will have amassed $98,977, versus $52,500 with simple interest over the same period.

Now just imagine the power of compounding interest, if you were making regular contributions to that savings account.

Compound interest and saving

Here's the good news: Compound interest is far more common than simple interest when you're talking about saving. There are a couple types of savings vehicles you can open to make compound interest work for you.

Certificates of deposit (CDs) are probably one of the safest places for you to keep your money and watch it grow. CDs offer the highest interest rates, but lock your funds up for a fixed term.

These terms vary anywhere from six months to five years or more, and there are penalties for withdrawing early.

Once the term has ended, you have the option to renew and keep your money growing in the CD or take it out. All previous accumulations will roll over into the next fixed term.

More: Open a no-penalty 11-month CD from CIT Bank

Of course, the locked nature of CDs can be restrictive, especially if you are planning on opening an emergency savings account you'll need quick access to.

You also won't be able to deposit more funds into the CD until it matures and is up for renewal.

High-yield savings accounts will give you flexibility to withdraw and deposit funds whenever you wish, and — although the interest rates won't be as high as the rates on CDs — the accounts provide solid returns over time.

But note that these accounts typically require a minimum deposit.

To keep your short-term savings more agile, a high-yield savings account might work best.

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Buffett on compound interest

Warren Buffett smiling and gesturing with both hands
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Please, oh please make me like Warren Buffett.

When you talk about successful investing, namedropping the Oracle of Omaha is inevitable. Warren Buffett is a shining example of how you can grow your money through compounding.

"My wealth has come from a combination of living in America, some lucky genes, and compound interest," he once wrote (CNN).

And if you take a look at examples of Buffett's portfolios, you'll notice he's mostly invested in stocks that pay dividends, which offer another form of compounding.

My wealth has come from a combination of living in America, some lucky genes, and compound interest." — Warren Buffett

One of the best things you can do, if you're OK with a little risk, is invest in a combination of stocks, mutual funds, and ETFs that pay dividends. Make sure you do your research.

Reinvested dividends that you earn will generate further dividends, and the compounding dance continues.

Let's take a look at the historical data for the S&P 500 Index as an example. Say you invested $100,000 from 2013 to 2017 in an index fund that mimics the S&P 500.

See how your investment would grow without(w/o) and with(w) dividend reinvestment.

S&P 500 Index dividend reinvestment gains

Year % Gain w/o % Gain w Final Balance w/o Final Balance w
2013 27.54% 30.50% $127,540 $130,500
2014 10.68% 12.94% $141,161 $147,387
2015 -1.44% 0.58% $139,129 $148,242
2016 7.32% 9.66% $149,313 $162,562
2017 16.95% 19.42% $174,621 $194,131

Reinvesting dividends cushioned your loss in 2015, and led to you nearly doubling your initial investment over the course of five years.

If you are regularly contributing to your stock portfolio in a well-thought-out approach, and reinvesting your dividends, the growth on average of your portfolio has the potential to look very green.

In the long term, maybe you won't see same the sort of growth that Buffett has over his storied career. But he can attribute his great success to smart investing, and relying on the power of compounding. And you'll be able to do the same.

If investing on your own intimidates you, there are many new technologies that do the heavy lifting for you and cut the cost of investment fees.

Whether you're saving in the short term, or investing for the long haul, compound interest is your best friend. So give it a hug, and let it work for you.

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About the Author

Rudro Chakrabarti

Rudro Chakrabarti

Editor

Rudro is an Editor with MoneyWise. His work has appeared on Yahoo Finance, MSN Money and The Financial Post. He previously served as Managing Editor of Oola, and as the Content Lead of Tickld before that. Rudro holds a Bachelor of Science in Psychology from the University of Toronto.

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