“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it”. – Albert Einstein
Whether he did make the remark or not, there is no denying the fact that the magic of compounding will help grow your money exponentially and build wealth.
What is compound interest?
Simply put, compound interest is the additional interest earned on reinvestment of your investment earnings. Therefore, it can be envisioned as an interest on your earned interest.
The mathematical formula for calculating compound interest is:
P = Principal (original Investment)
r = Rate of return
t = Number of compounding periods or the compounding frequency
How does compound interest work?
What makes compounding so special is the way it works over time. So even if you do not add a single penny to your initial investment, the magic of compounding ensures that your money keeps growing exponentially!
Unlike simple interest, which is calculated on your original investment (principal) only, the compound interest gets calculated on your original principal and the accumulated interest. This means your investment will grow at an accelerated pace allowing you to reach your financial goals.
To appreciate how it can help build your future nest egg, you’ll have to first understand the two main aspects of compound interest.
The secret ingredient that makes compound interest the single biggest creator of wealth is the lesser-known aspect of compounding frequency. It is the number of times interest is calculated and added to the principal in a single year. The concept of “interest on interest” allows you to earn additional income on your investments.
To illustrate why it’s so important to know when your investment compounds, we’re breaking it down in a helpful side-by-side.
If you invest $1,000 at 3.00% APY* for five years:
- The simple interest for five years would be $1,030.
- The compound interest for five years (compounded annually) would be $1,159.27.
- The compound interest for five years (compounded semi-annually) would be $1,160.54.
- The compound interest for five years (compounded monthly) would be $1,161.62.
Annual Percentage Yield (APY)
This refers to the actual rate of investment return calculated after incorporating the effect of compounding interest.
The mathematical formula for calculating APY is:
APY = (1+r/t)^t-1
r = Rate of return
t = Compounding frequency
The real rate of interest earned on your investments with monthly compounding would be higher than what you would make on a quarterly or yearly compounding basis. In short, the faster the compounding frequency, the greater is your accumulated interest and the percentage yield for the year.
Using compound interest to build your wealth
Now that you understand the power of compounding, here are a few ways to build that sweet nest egg!
1. Start saving early
For compounding to work its magic, time is your ally. The more time you give your money to grow, the more it will compound. So start saving early by putting money in a high-yield account regularly. If you do frequent banking transactions or have multiple monthly bills to pay, consider shifting your money to a high-yield checking account, or better yet, a hybrid savings/checking account that will also earn interest while you pay your bills.
With One’s high-yield checking account, you will be able to do both! Use your Spend Pocket to pay bills while simultaneously earning excellent interest rates on your Auto-Save Pocket using card Auto-Save. You’ll automatically put a little money aside every time you spend.
2. Shop around for the best rates
When it comes to money, it pays to be objective. Don’t just settle for the traditional neighborhood bank for putting in your hard-earned money. Instead, do your research and shop around for a high-yield checking account that offers the best APY in the industry. Remember, the higher the APY, the more interest you’ll earn! One offers industry-leading rates of 3.00% APY* in the Auto-Save Pocket and 1.00% APY* on Save Pocket balances.
3. Watch out for compounding frequency
Always remember, the more frequent the compounding, the more interest you will receive on your money. So, while comparing the APY offered by different high-yield checking accounts, look into the fine print on their compounding frequency. You’ll notice that the account with the higher compounding frequency will be the one offering the better APY. One offers monthly compounding for every customer. Watch your money grow automatically!