Compound interest is the interest earned on an investment that builds on previous interest. Essentially, it’s interest on interest.
What it means:
Often associated with personal savings and investments, mortgages, and credit cards, compound interest can help grow (or quickly deplete) your savings over time. It does this by snowballing accrued interest into the principal of an investment or loan. If interest is compounded annually, for example, interest earned this year gets added to the total sum used to calculate interest next year. From a saver’s perspective, it means that your savings or investment will grow exponentially.
To understand what this could look like, imagine you’ve just invested $5,000 in a Guaranteed Investment Certificate (GIC) with a 3% interest rate. With compound interest, you’ll earn $150 ($5,000 x 3%) of interest in the first year of your investment. The following year, you would earn $154.50 ($5,150 x 3%). This would continue as long as you leave the account to grow. Although even a few years of compound interest can make an impact on your savings, the power of compound interest is more apparent over longer periods of time.
However, compound interest can also work against you, particularly in the case of loans or debt. From a borrower’s perspective, unless you are making regular payments against a loan’s principal, the debt will likewise grow exponentially.
There’s a simple way to calculate how long it will take for an investment to double with compound interest: Investors often use what’s called the Rule of 72. By simply dividing 72 by the interest rate offered, you can see approximately how long it would take to double your money. Compound interest can be a fairly simple way for investors to grow their wealth over time. But if you’re on the other side of the equation and have borrowed money with compound interest, you can see how easy it might be for that debt to quickly build up.