Whether you’re looking to upgrade your savings account, boost your investments or take on a new loan, compound interest could be a crucial factor at play. Understanding what it is and how it works, in the context of both savings and loans, is an essential building block for good money management.
What Is Compound Interest?
Compound interest typically refers to growing your money by earning interest not just on the original amount (the principal) but also on the interest itself. Think of it as a snowball effect: as interest is added, the total amount grows larger, and the next round of interest is calculated on that larger sum.
Example:
| Simple Interest | Compound Interest | |
| Principal Investment | $10,000 | $10,000 |
| Annual Interest Rate | 5% | 5% (compounded monthly) |
| Total Investment After 24 months | $11,025 | $11,049 |
The difference may seem small at first, but over time, this “interest on interest” effect can lead to significant growth, especially when the interest compounds more frequently.
Learn more: Is It Worth Putting Money In A Savings Account In Canada?
Compounded Interest Formula
The formula for calculating compound interest is the same whether you’re earning with savings or investments.
A=P×(1+nr)n⋅t
- A = the total amount after interest
- P = the principal amount
- r = annual interest rate (in decimal form, e.g., 5% = 0.05)
- n = number of compounding periods per year (e.g., monthly = 12, daily = 365)
- t = time in years
For savings, compound interest helps your money grow over time. Each time interest is calculated, it’s added to your initial deposit, creating a larger base for the next calculation. Compounding periods can work weekly, monthly or yearly – the more frequently the interest is compounded, the faster your money will grow.
Compounding Interest – Savings
Compound interest is one of the most powerful tools for growing your savings or investments. It allows your money to grow exponentially over time because you’re not just earning interest on your original deposit, but also on the interest that accumulates.
If we continue with the example shared above, with an initial deposit of $10,000 with a 5% annual compounded interest rate, your investment will reach a total of $11,025.00 after two years. And over 10 years, your investment of $10,000 would grow to $16,288, without you adding another cent.
If the interest were compounded monthly instead of annually, the same $10,000 would reach a total of $16,470 after 10 years, as more frequent compounding will result in more growth on the principal investment.
Benefits Of Compounding Interest – Savings
Compound interest offers several key advantages for your savings and investments.
Grow Your Money Faster
With compound interest, your money grows exponentially in comparison with simple interest. Unlike simple interest, where you only earn interest on your initial deposit, compound interest adds the interest back to your balance, allowing your savings to grow more with each compounding cycle.
More Time Equals More Money
The longer your money is invested, the more significant the impact of compounding will be. Time is your greatest ally here, because the “interest on interest” effect will accelerate as time goes by.
Combat Inflation
One of the challenges of saving is ensuring your money retains its purchasing power. Inflation erodes the value of money over time, but compound interest can help you stay ahead. By earning interest on your savings and reinvesting it, you can grow your money faster than inflation rises, preserving and even increasing your wealth.
Source of Passive Income
Compounding interest is a great way to generate truly passive income. Once you set up your savings or investments, the interest begins to work for you, continuously earning more interest without any further management or investment. This “snowball” effect means that over time, your money generates income on its own.
Maximize Long-Term Wealth
Compound interest is ideal for long-term wealth-building, because the earlier you start saving or investing, the more time your money has to compound. This makes compounding an essential strategy for goals like retirement or saving for your children’s education, where the growth over decades can be significant.
Compounding Interest – Loans
Compound interest isn’t limited to savings – it can also apply to loans and credit cards. On the borrowing side, compounding interest means you could end up paying much more than the original loan amount if you don’t manage your debt carefully.
When it comes to loans or credit cards, compound interest is calculated the same way as savings, except here, the interest is calculated as money owed, not saved. So the longer you take to pay off the loan, the more interest you will end up paying.
What Is The Difference Between A Simple Interest Loan And Compound Interest Loan?
The key difference between a simple interest loan and a compound interest loan lies in how interest is calculated and added to the balance.
Simple Interest Loan
Personal installment loans generally have a simple interest. Simple interest is calculated on the original principal amount and remains the same throughout the term of the loan. Meaning the interest amount you pay does not change with each payment.
For example, if you borrow $1,000 at a 5% annual interest rate for one year, you’ll pay $50 in interest for the entire year, no matter how much you’ve already paid off.
| Month | Principal Payment | Interest Payment | Total Payment | Remaining Balance |
| 1 | $83.33 | $4.17 | $87.50 | $916.67 |
| 2 | $83.33 | $4.17 | $87.50 | $833.33 |
| 3 | $83.33 | $4.17 | $87.50 | $750.00 |
| 4 | $83.33 | $4.17 | $87.50 | $666.67 |
| 5 | $83.33 | $4.17 | $87.50 | $583.33 |
| 6 | $83.33 | $4.17 | $87.50 | $500.00 |
| 7 | $83.33 | $4.17 | $87.50 | $416.67 |
| 8 | $83.33 | $4.17 | $87.50 | $333.33 |
| 9 | $83.33 | $4.17 | $87.50 | $250.00 |
| 10 | $83.33 | $4.17 | $87.50 | $166.67 |
| 11 | $83.33 | $4.17 | $87.50 | $83.33 |
| 12 | $83.33 | $4.17 | $87.50 | $0.00 |
| Total | ~$1,000 | ~50.04 | ~$1,050 | – |
That said, if your lender allows prepayments, you could reduce the total amount of interest you pay over the course of the loan.
Compound Interest Loan
In contrast, loans such as credit cards use compound interest. As your balance is carried forward month to month, interest is charged on the principal and interest charged from the previous month.
In this example, you’ll see that the interest charged each month increases. This is because the interest is calculated on the new balance which includes the interest charged in the previous month.
Let’s assume you have a credit card with a 21% annual interest, compounded monthly and a credit card balance of $1,000 that you carry over for 6 months.
| Month | Credit Card Balance | Interest Added each month |
| 0 | $1,000.00 | $0.00 |
| 1 | $1,017.50 | $17.50 |
| 2 | $1,035.94 | $18.44 |
| 3 | $1,054.31 | $18.37 |
| 4 | $1,072.61 | $18.30 |
| 5 | $1,090.94 | $18.33 |
| 6 | $1,109.20 | $18.26 |
When it comes to loans, interest is calculated on the remaining balance, and if you’re not making payments, debt can accumulate quickly. However, regular payments will also reduce the principal amount, which in turn will help to slow down the rate at which interest grows.
Key Differences
Interest Calculation: Simple interest is calculated only on the initial loan balance, while compound interest is calculated on both the original loan and the accumulated interest.
Total Loan Cost: Compound interest typically leads to higher costs over time because interest compounds on the unpaid balance, whereas simple interest remains more predictable and less expensive in the long run.
Loan Duration Impact: Compound interest can lead to significant growth in the amount owed, especially if the loan is long-term or if the interest compounds frequently. Simple interest, on the other hand, remains the same throughout the loan term, assuming no prepayments are made.
Other Calculators
Bottom Line
Compounded interest can be a fantastic tool to help grow your savings and generate truly passive income from investments, especially if the compounding periods are short. However, compounded interest can also work against you when it comes to certain types of loan products, credit cards in particular.
Either way, compounded interest is something you’ll want to look out for with any loan, savings or investments accounts that you’re interested in.
