Simple and Compound Interest

Compounding is the secret to making your investments grow as quickly as possible. Banks know this well. That's why their credit cards all charge you interest compounded daily. But what does "compounding" really mean?

Let's say you have \$1,000 in the bank. The bank's current interest rate is 2%. With simple interest, your investment will earn .02 x 1000 = \$20 in one year. (Of course bank service fees and inflation have both well outsripped the interest earned so that, in real dollars, you now have less than \$1,000 - but that's another story.

If, however, the bank paid you this interest every month and you left it in your account, you would be receiving compound interest. For the first month, your interest would be .02/12 x 1000 = 1.67. We add the interest to your deposit. Your balance is now \$1,001.67 and the interest on that amount for the second month is .02/12 x 1001.67 = \$1.67! Wait! That's the same as last month, isn't it? Well it is, but the fraction is higher. Wait until next month. In fact, here's a chart for the year.

MonthStart BalanceInterestNew Balance
January\$1,000.00\$1.67\$1,001.67
February\$1,001.67\$1.67\$1,003.34
March\$1,003.34\$1.67\$1,005.01
April\$1,005.01\$1.68\$1,006.69
May\$1,006.69\$1.68\$1,008.37
June\$1,008.37\$1.68\$1,010.05
July\$1,010.05\$1.68\$1,011.73
August\$1,011.73\$1.69\$1,013.42
September\$1,013.42\$1.69\$1,015.11
October\$1,015.11\$1.69\$1,016.80
November\$1,016.80\$1.69\$1,018.49
December\$1,018.49\$1.70\$1,020.19

The power of compound interest has earned you an additional 19 cents! Okay, so what's nineteen cents? Not much, admittedly, but we're dealing with a relatively small investment and a miniscule interest rate. And don't forget, that's an extra 19 cents every year (which will, itself, get compounded eventually). Want to see more dramatic results? Just click here.

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