Highlights:
- Compound interest is when the earnings from your savings start to generate earnings of their own.
- Compound interest accounts include savings accounts, investment accounts, and even some checking accounts.
We’ve all heard the generic financial advice:
It takes money to make money.
Invest early, invest often.
A penny saved is a penny earned.
Make your money work for you.
There's a common thread that links all these financial rules of thumb together. It’s a concept called compounding interest, and it’s a pretty big deal.
It can also be a bit confusing. So what is compound interest, exactly? And how can compound interest accounts make your money a marvel?
What is compound interest?
First, let’s define interest. Interest is the earnings your savings generates when you keep it in a savings account or another similar savings vehicle. If you deposit $100 in an account that earns 1% interest, you’ll earn about $1 per year in interest.
Compound interest is when the earnings from your savings start to bring in earnings of their own. Compound interest works because interest payments are deposited into your account and immediately start earning interest themselves.
If you deposit $100 for that first year, you’ll earn interest on your $100 deposit — $1 gets added to your account. In the second year, you’ll earn interest on your $101 balance — the original investment plus the $1 you’ve already earned.
Over the long run, and particularly when higher interest rates are involved, compound interest can help your account balance grow more quickly. It’s vital to the success of long-term investing and wealth building.
Of course, compound interest can also work against you. If you have credit card debt, for instance, the interest costs are added to your balance and start accumulating their own interest costs, leading to a debt snowball effect.
Because compound interest can either work for or against you, it’s an important concept to understand. People of all ages and walks of life can benefit from understanding the power of compounding interest accounts.
If you’re just getting started on your financial journey, it helps to conceptualize the long-term effects of compounding. For this, look at the examples listed below.
If you’re a parent, explaining compound interest to your kids is an important component of financial literacy. You could encourage them to save or teach them to invest part of their allowance to start earning interest themselves! Or, use Greenlight’s Parent Paid Interest feature to show them how compound interest works in the real world.
Before we get much further, let’s cover the bases with some terms you should know:
Simple interest is a term that refers to interest that is not compounded. Certain accounts are structured so that the interest earned only applies to the principal amount in the account and not the interest the account has already earned. The simplest way to conceptualize simple interest is to think of a situation in which you immediately spent all the interest you earned on your account. In this case, the interest payments would not earn interest of their own and would, therefore, not be considered compounding interest.
Annual percentage yield (APY) is a term that refers to the interest earned in one year’s time on savings accounts and certain investments. It's an accurate measure of how much you’ll earn because it already accounts for compounding interest.
Examples of compounding
To conceptualize how compounding works, let’s look at several unique examples with variable compounding periods and rates. APYs of around 2% are used to simulate savings in a compound interest account like a high-yield savings account, while APYs of around 10% are used to simulate long-term returns from higher-risk investments like stocks.
A one-time deposit of $1,000 saved at 2% APY would be worth:
$1,020 after 1 year
$1,218.99 after 10 years
$1,811.36 after 30 years
A one-time deposit of $1,000 saved at 10% APY would be worth:
$1,100.00 after 1 year
$2,593.74 after 10 years
$17,449.40 after 30 years
You can see how compound interest accounts grow your savings balance over time. But compounding becomes possible when your investment strategy involves consistent monthly investments. These next examples show the true power of compounding interest plus investments in the stock market or other growth assets.
A monthly deposit of $200 saved at 2% APY would be worth:
$2,604.00 after 1 year
$26,523.13 after 10 years
$97,725.66 after 30 years
A monthly deposit of $200 saved at 10% APY would be worth:
$2,620 after 1 year
$38,768.57 after 10 years
$398,275.53 after 30 years
Want to test out your own savings scenarios? Use this compound interest calculator.
Types of compound interest accounts
To take advantage of the power of compounding, start investing or saving in a specific type of compounding interest account. Here’s an overview of your options.
Savings accounts
Savings accounts are one kind of compound interest account offered by banks, credit unions, and online financial institutions. They are extremely safe, as funds are FDIC-insured. Yields are relatively low. However, high-yield savings accounts may pay 1–2% APY on your funds.
Some checking accounts
Most checking accounts do not earn interest, or they earn an extremely low amount, like 0.01% APY. However, certain rewards checking accounts may pay a reasonable interest rate and can benefit from compounding interest.
Money market accounts
Money market accounts are compound interest accounts that are similar to savings accounts, but they combine certain features of checking accounts as well. They may offer check-writing capabilities and/or access to ATMs, but they typically aren’t meant to fully replace a checking account.
Certificates of deposit (CDs)
CDs are financial products offered by banks and credit unions. They require you to lock up your money for a period of time — usually 3 months to 5 years — in exchange for a higher interest rate. Interest is periodically added back to the principal amount, increasing the balance that is earning interest.
Brokerage accounts
Brokerage accounts are offered by large financial firms. These accounts offer access to a wide range of investment opportunities with various rates of return and risk levels. Most investments can benefit from the concept of compounding, including dividend stocks, index funds, and certain mutual funds. By default, brokerage accounts are available to those over 18 — but specialty accounts like Greenlight Max allow parents and children to work together to start investing.
Compounding interest and your financial goals
A big part of success in personal finance is defining your financial goals and taking actionable steps towards those objectives. Everyone’s goals are different, but the principles of compound interest can benefit just about any financial goal.
Here are just a few examples of how compound interest can help you make progress.
Saving money: Whether your goal is to build an emergency fund, save up for a vacation, or simply build a financial cushion, saving money in a high-yield savings account is a great idea. Look for an account with a reasonable APY so that your money can grow faster!
Teaching kids about money: Compounding interest is an important part of teaching kids financial literacy. Parents can provide examples of compounding growth (see above) or could even choose to set Parent-Paid Interest with a child’s Greenlight account. With Greenlight, for instance, a parent could offer 10% interest on anything their child saves, with interest deposits automated monthly. See terms of service.
Saving for retirement: Open a retirement account like a Roth IRA or 401(k), and start investing in stocks, bonds, or other growth assets. The growth of your account balance will benefit from compound growth, especially if you set things up to automatically reinvest any dividends (interest) and distributions (company profits distributed to shareholders).
Saving for your children’s future: Open a 529 plan and start investing in growth assets. 529s offer tax perks, as well as the option to invest in a variety of assets. Parents can also benefit from introducing the Greenlight app to their kids and teens. Greenlight is an all-in-one money app for kids, so they can learn to save, earn, and invest under one digital roof. Kids can even earn up to 5% on their savings with Greenlight Infinity¹. Meanwhile, parents can earn up to 3%* back on their spending by using the Greenlight Family Cash Card.
Paying off debt: Remember, compound interest can also work against you when it comes to debt. Here’s a powerful mindset switch: Each time you make a payment towards your debt, think about all the interest you won’t have to pay in the future!
Make your money work for you
Compound interest can help your money grow faster and faster over time. It’s one of the key secrets to wealth building, and it’s particularly powerful over long periods of time.
If you’re a parent, compound growth is particularly important to understand. It’s important for teaching kids about stocks and investing and also for helping them out financially.
For instance, how much do you think you’d need to invest for a newborn child in order for them to retire a millionaire?
Believe it or not, if you invest just $2,050 one time and earn 10% returns (the long-term average for the US stock market) for 65 years, you’d end up with just over $1,000,000. That's a big chunk of change!
¹Greenlight Core and Greenlight + Invest families can earn monthly rewards of 1% per annum, Greenlight Max families can earn 2% per annum, and Greenlight Infinity families can earn 5% per annum on an average daily savings balance of up to $5,000 per family. Only Greenlight Max and Infinity families can earn 1% cash back on spending monthly. To qualify, the Primary Account must be in Good Standing and have a verified ACH funding account. See Greenlight Terms of Service for details. Subject to change at any time.
*Earn 3% when you spend at least $4,000 in a billing cycle, 2% when you spend at least $1,000 but less than $4,000 in a billing cycle, and 1% when you spend <$1,000 in a billing cycle. See the Credit Card Rewards Terms and Conditions for details, including earning, redemption, expiration or forfeiture.
