How Does Compound Interest Work?

One of the most effective ways to save is to find opportunities that include compound interest. Keep reading to learn how compound interest works.

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Adam Moelis
Nov 15, 2022
18 min read

Saving money is crucial to stay on top of your personal finances. Reckless spending and disregarding your funds are a recipe for disaster. The problem is that saving money can be pretty tricky, especially when trying to save for the distant future and retirement. 

Opening up a savings account can help you to stash away some money. Having a little extra money for a rainy day is always a good idea. You never know when the next disaster might strike or how long it will last. 

Unfortunately, keeping the money secured isn’t going to be good enough. You need to put your savings to work and make them grow even bigger. One of the easiest ways to do that is to seek investment opportunities with the best annual interest rates. 

What Is Interest?

Interest is the amount of money that’s charged or earned on a specific amount of money. Few things in the financial world don’t have some type of interest rate attached. 

For instance, mortgages, car loans, student loans, and credit cards all come with a fixed interest rate. The longer it takes to repay these debts, the more you’ll owe in interest. The goal when borrowing money is to seek the option with the lowest interest rate. 

On the other hand, interest can also be applied to savings account options, bonds, money market accounts, and certificates of deposit. The longer you maintain these accounts with minimal withdrawals, the more money you’ll accrue in your account balance, thanks to the power of compounding interest. While you’ll want lower interest rates from lenders and on credit cards, in this case, you’ll want to find the highest interest rates as they’ll earn you more money over time. 

How Does Interest Work? 

Not all interest functions the same way. Essentially, two types of interest can be applied to a debt or savings account: simple and compound. The difference between the two can add up to a ton of money in the long run. 

Simple interest means that interest payments are calculated based on the principal amount. For example, car loans usually come with simple interest rates, so the included interest doesn’t generate additional interest. You would only need to pay interest based on the total amount of money that you borrowed upfront. 

For example, a $20,000 car loan with a 3.5% interest rate and a term of 60 months would accrue a total of $1,830 in interest. 

The interest would be factored in before you made the first payment. Each month you would make an equal payment of $363.83 — the first payment would feature the largest interest payment ($58.33) and the lowest principal payment ($305.50). 

Over time, the interest payment will decrease, and the principal payment will increase. The final payment would only involve $1.06 toward interest and $362.77 toward the principal.    

Compound interest is a little more complicated, as it is calculated based on the principal and the accrued interest. Credit cards usually include compounding interest, which is why paying them off is so hard. 

You should try to avoid incurring that comes with compound interest. However, you should look for investment opportunities with compound interest, as you can make much money over compounding periods. 

The easiest way to explain it is using an example: 

  • Let’s say that you open an account with a six percent rate of return annually and make an initial deposit of $2,000. 
  • The principal ($2,000) would earn $123.36 in interest payments after the first year, increasing your balance to $2,123.36.
  • Now let’s say that you contribute an additional $1,000 on top of your initial investment each year going forward.
  • You would start the year with $3,123.36 (the year one principal plus the interest plus the year two contribution).
  • By the end of the second year, you would earn an additional $192.64 in interest payments bringing your total to $3,316. 
  • Adding your annual contribution of $1,000 would increase your balance to $4,316.00.
  • By the end of the third year, you would earn an additional $266.20 in interest payments bringing your total to $4,582.20.
  • You can see how the interest is starting to add up after just a few years. Continuing to make an annual contribution of $1,000 yearly will yield much more significant results.
  • By the end of the fifth year, you would earn an extra $427.21 in interest payments and have a balance of $7,353.71.
  • By the end of the tenth year, you would earn an extra $925.09 in interest payments and have a balance of $15,923.91.
  • By the end of the twentieth year, you would earn an extra $2,502.51 in interest payments and have a balance of $43,076.41.
  • By the end of the thirtieth year, you would earn an extra $5,372.45 in interest payments and have a balance of $92,477.60.
  • By the end of the fiftieth year, you would earn an extra $20,094.13 in interest payments and have a balance of $346,885.97.
  • After fifty years, you would have contributed $52,000 to your account, which is about $2.74 daily. As a result of compound interest, you would have earned $294,885.97 in accumulated interest payments on your original principal investment over a larger number of years.

You should be able to see why compound interest is such a prized commodity in the financial world. Even a relatively low-interest rate of 2.5% would double your principal investments after 50 years. 

Using the same information from above would earn you more than $53,269.72 in accrued interest. A simple interest rate would ignore the accrued interest on your account. You would only generate interest based on the principal balance of your account. 

What Is the Rule of 72?

The formula used for a compound interest calculator is relatively advanced and hard to explain. Fortunately, economists have derived the “Rule of 72” to help easily calculate compound interest

This compound interest formula will help you determine how long it will take to double your money. All that you have to do is divide 72 by the interest rate on an investment account like an IRA or mutual fund. 

You would double your money in:

  • 36 years with a 2% annual percentage yield (APY)
  • 24 years with a 3% annual percentage rate
  • 18 years with a 4% annual percentage rate
  • 12 years with a 6% annual percentage rate
  • Nine years with an 8% annual percentage rate
  • Eight years with a 9% annual percentage rate
  • Six years with a 12% annual percentage rate
  • Four years with an 18% annual percentage rate

The Rule of 72 isn’t an exact calculation and should only be used to give you a rough estimate of accrued interest. We can use the information from the previous example to test the accuracy of the rule. 

Taking contributions out of the question, an account with an initial deposit of $2,000 would accrue $2,024.39 in interest during its 12th year — 72 divided by six is 12, which means the Rule of 72 is spot on for this example. 

Are There Alternatives to Compound Interest?

It should be clear by now that you should look for long-term investment opportunities with compound interest. Especially compound interest that accrues daily as shorter compounding terms will increase the amount of interest that you earn

You should always be on the lookout for investment opportunities that feature a high compound interest rate. However, that’s not the only way to make money over time. 

Using prize-linked savings is another way to grow your money over time. Most investment opportunities feature fixed interest rates that slowly generate money over time. 

The good thing about these plans is that you can calculate exactly how much you’ll make during any given period. Prize-linked savings offer interest payments differently. Specifically, you’ll receive entries into weekly sweepstakes in place of interest payments. 

The Yotta weekly sweepstakes are pretty straightforward. You’ll receive one ticket for every $25 in your account. Each ticket has six numbers and a Yotta Ball, and the weekly drawings begin at 9 PM EST on Monday and continue through Sunday. 

Depending on how many of the seven numbers that your tickets, you could win prizes ranging from ten cents to ten million: 

  • Two numbers and no Yotta Ball: $0.01 per ticket
  • Three numbers and no Yotta Ball: $0.20 per ticket
  • Four numbers and no Yotta Ball: $7.00 per ticket
  • Five numbers and no Yotta Ball: $5,000
  • Six numbers and no Yotta Ball: $50,000
  • Just the Yotta Ball: $0.10 per ticket
  • One number and the Yotta Ball: $0.20 per ticket
  • Two numbers and the Yotta Ball: $0.75 per ticket
  • Three numbers and the Yotta Ball: $10 per ticket
  • Four numbers and the Yotta Ball: $4,000
  • Five numbers and the Yotta Ball: $15,000
  • Six number and the Yotta Ball: $10,000,000

In the earlier example, a compound interest rate of 6% would take 50 years and $52,000 in contributions to earn close to $300,000. With Yotta, you could win more than 30 times that amount in a single week. 

There’s no guarantee that you’ll hit the Yotta jackpot. However, sweepstake entry is based on your savings and doesn’t cost you anything. You have nothing to lose and potentially millions to gain. 

The Bottom Line: Use the Power of Compound Interest

Albert Einstein called compound interest the eighth wonder of the world, and it’s easy to see why.

Compound interest can be devastating when applied to your credit card debt and very lucrative when applied to your investments over a long time frame. 

It’s never too soon to start planning for the future and taking advantage of compound interest. The earlier you start saving with a compound interest rate, the larger the money you’ll earn in interest. 

On the other hand, you could opt for a different type of interest payment. The Yotta sweepstakes are free for users with at least $25 in their account. 

Dedicating money that can grow via compound interest is a good idea. It’s also a good idea to play what users often describe as a “no-lose lottery.” 

Visit Yotta today to learn more, set up your account, and make your first deposit. With some luck, you can double your money much faster than even the friendliest Rule of 72 calculations.

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