Compound Interest 101: The Benefits of Saving Early

Tom Gilmour is a senior director of planning experience integration for Northwestern Mutual.

You’ve heard the advice time and again: Start saving as soon as you possibly can so you can harness the power of compound interest. But when you have a savings account that only earns, say, 1 percent a year, you’re probably thinking, “What’s the point?”

You may not realize just how helpful compound interest can be when you’re trying to grow your money. After all, compound interest isn’t only what you earn on your principal, it’s also interest earned on interest.

It sounds like a riddle, but it’s actually a financial concept worth understanding if you’re trying to save—as well as pay down debt. Here’s a quick lesson in how compound interest works.

What is compound interest?

Compound interest is the interest earned on your original deposit—your principal—and the accumulated growth in your account. In other words, it’s what happens when the interest you earn begins to accrue interest of its own. Over time, this additional interest can have a big impact on your savings growth.

Understanding compound interest vs. simple interest

To understand how compound interest works, it’s important to understand how it differs from simple interest.

How simple interest works

It’s easy to confuse the two, but there are some major differences. To begin with, you’ll hear simple interest referenced more often with respect to borrowing money. Calculating how much you pay in simple interest is, well, simple: It’s the principal multiplied by the interest rate multiplied by the term of the loan. Here’s a formula that you can use:

Let’s say you take out a $1,000 loan that charges you 5 percent annual interest, which you have agreed to pay off in five years. At the end of the loan term, you will have paid $250 total in interest ($1,000 * 0.05 * 5).

Some loans use simple interest, though many common loans, such as mortgages and auto loans, are amortized and may not behave exactly like the simple formula in practice.

How compound interest works

Compound interest, meanwhile, is based on an exponential calculation in which interest is charged (or earned) based on the principal amount plus whatever interest has been accumulating over time. While there are plenty of calculators you can use to determine compound interest of a given scenario, you can also use this formula:

So, using the same $1,000 example, if that 5 percent interest was compounded annually, at the end of the five years the total interest you’d pay would add up to $276.28 (1,000 * (1 + (0.05 / 1)) ^ (1*5)) - 1000).

Using the “Rule of 72”

If you don’t want to use the complicated formula above, you can still see how compound interest will affect your investments by using the Rule of 72. This allows you to estimate how long it would take for an investment to double at a particular interest rate. To calculate, divide the number 72 by the interest rate. The resulting number is the number of years that it would take for the principal to double.

Imagine that you deposit $5,000 into an interest-bearing account earning 4 percent annually. Using the rule of 72, it would take your money approximately 18 years to double (72 divided by 4). Alternatively, if you had $5,000 invested, earning an average annual return of 8 percent, it would take your money nine years to double (72 divided by 8).

Note that these examples do not take new contributions into consideration. Any additional contributions would help your money grow even faster.

Why compound interest matters

Compound interest is one of the most powerful forces in personal finance, controlling not just how much money your long-term savings and investments earn but also how much your debt grows over time.

This is why compound interest in a borrowing scenario is not your friend. Ever wonder why your credit card balances seem to grow so fast? In addition to charging high interest rates, many credit card companies compound the interest they charge you daily. Together, it’s clear to see why credit cards are typically considered bad debt. If you carry over balances, you’re being charged interest on the previous interest you didn’t pay off (on top of whatever purchases you’ve made). That’s why many debt repayment strategies focus on paying down loans with the highest interest rate first, or on consolidating multiple high-interest debts to one with a lower interest rate.

But if you’re saving or investing, compound interest—or compound growth, if we’re talking about returns on investments—can be your best friend, particularly if you’ve got time on your side. Compound growth can be especially powerful when you’re saving in tax-advantaged retirement accounts, because taxes are deferred until you start making withdrawals in retirement. This means you’ll have more money invested for longer.

Types of accounts that can earn compound interest

If you’re interested in using compound interest to your advantage, it’s important to make sure you’re using the right types of account to save or invest your money. That’s because not all accounts are created equally. Checking accounts and many traditional savings accounts, for example, typically earn such a low interest rate that they aren’t really a good tool for growing your wealth over time.

Accounts that can help you take advantage of compound interest include:

• High-yield savings accounts: These accounts offer much higher interest rates than traditional savings accounts.
• Certificates of deposit (CDs): These bank products require you to leave your money deposited for a specified period of time (anywhere from a few months to 10 years) in exchange for higher interest rates.
• Money market accounts: These are a special type of savings account that merge features of traditional savings accounts and checking accounts, and which typically offer higher interest rates than either of those accounts.
• Retirement accounts and brokerage accounts: These accounts can hold investments such as bonds, mutual funds, ETFs and stocks. Interest, dividends and reinvested earnings can all contribute to compounding over time.

Why it’s important to start saving early

If you ever needed a carrot to dangle to kickstart your saving—especially for long-term goals like retirement—try plugging a few numbers into this compound interest calculator from Investor.gov. Here’s an illustration to show you what we mean:

Consider a man who hasn’t thought much about saving for retirement until he reaches the age of 40. Suddenly, he realizes he’s got to get on the ball. So he starts funneling $800 a month into his retirement account and he keeps it up until he reaches 67. If his investments return a hypothetical 6 percent per year, by the time he’s ready to retire, he will have $611,575 waiting for him. Not too shabby, right?

Now let’s look at a woman who decides at age 30 that she’s going to start directing $500 a month to her retirement account. She earns the same hypothetical 6 percent return per year, and also continually contributes until she turns 67. When she’s ready to retire, she’s got $763,609 waiting for her.

Even though the woman contributed less each month than the man in our example did, she ended up with $152,034 more in her nest egg. Why? Because she got a 10-year head start on saving. And if she had contributed the same $800 a month as he did, her total would have been more than $1.2 million!

That is what we mean when we refer to the power of compound interest, and it’s precisely why you keep hearing the advice to start saving as soon as possible. The sooner you start, the more time your money has to grow—and the better you’ll be able to reach your nest-egg dreams. Your Northwestern Mutual financial advisor can help you make sure you’re investing the right amounts—and in the right accounts—so compound interest is working for your benefit.