You're probably familiar with the interest rate a bank pays you when you put money in a savings account, for example. Compound interest takes saving to another level, because it represents interest you earn on both the money you put in and the interest on that money. This interest on top of interest can quickly build upon what you save.
Compound interest: a definition
Unlike simple interest, where you earn a set rate annually, compound interest allows interest to grow on top of interest. It is calculated based on the initial principal amount (the initial size of the deposit) as well as the interest it accumulates over time. Compound interest is the secret to savings and investing.
The compound interest formula considers:
- Your principal amount
- Interest rate
- Time and compounding periods, which are typically daily, monthly or annually
- The result? The amount of interest you'll save over that period of time.
The compound interest formula is:
Initial principal amount multiplied by (1 plus the annual interest rate, divided by the number of compounding periods in a year, raised to the number of compounding periods multiplied by time)
A = P (1 + r/n) (nt)
P is your principal (initial deposit)
r is the annual rate of interest as a decimal
t is the length of time the principal is on deposit
n is the number of times interest is compounded per unit of t
A is the future value you will have at the end of the time period
You can use the formula to explore different scenarios and see how compound interest can make a real difference in your savings and life goals.
Compound interest formula in action: daily, monthly and yearly compounding
Let's see how the compounding interest formula works to boost your savings. For example, say you want to deposit $10,000 in a savings account that earns a 2.3%* annual rate of return. Use the compound interest formula to calculate the amount you would have at the end of a savings period for different compounding options.
A = P (1 + r/n) (nt)
Starting with a balance of $10,000 and a 2.3%* annual rate of return, after one year you can possibly end up with as much as $10,233 in a savings account.
What you should know about compound interest and your savings accounts
When you open or add money to a savings account, read the details to determine how frequently interest compounds for your account. You can also use a compound interest calculator to estimate how much money you are likely making by earning interest on your interest.
Compound interest can result in you having more money in your account each month. You can have more financial freedom and an easier journey towards your savings goals.
How compound interest can help you achieve your goals
- Looking to save money for your first house?
- Hoping to plan a vacation to remember?
- Simply wanting to feel more confident about your finances?
Compound interest can help you achieve your goals faster, increase your savings power and set you on a strong financial path. No matter what you're saving for, you are helping out your future self in a measurable way by using compound interest to increase your savings.
Damon is the content editor for Citi
*Rate provided is for illustrative purposes only.
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