What Is Compound Interest? How It Affects Loans and Investments

Compound interest is a financial term that describes earning “interest on interest.” It’s beneficial for saving and investing because each month, you earn interest not only on the amount you initially save or invest but also on any new interest earned, increasing your savings and investment balances more rapidly.

When you have a loan with compound interest, however, it works in reverse. That means that interest accrues on your original debt amount plus added interest costs. This can make a compound interest loan harder to pay down quickly. Here’s everything to know about compound interest.

What is compound interest?

Compound interest means you accrue interest on the original amount of money you save or invest (or the original amount of the money you borrow) and on the interest you’ve already earned. Much like a snowball that gets larger and larger as more snow accrues, your investments or debt balances grow much faster when compounding.

Here is an example: Suppose you deposit $100.00 in a savings account that earns 5% interest calculated monthly. The first month, you’ll earn $5.00 in interest, making your total balance $105.00 as you head into your second month.

In the second month, you’ll earn 5% interest not only on your original $100.00 but also on the $5.00 in interest too. This makes your new balance heading into the third month $110.25 (because 5% of $105.00 is $5.25.) 

Month	Starting balance	Monthly interest (5%)	Ending balance
1	$100.00	$5.00	$105.00
2	$105.00	$5.25	$110.25

This is a simple example, but it illustrates how compound interest can dramatically increase your savings over time.

How does compound interest work?

To understand how compound interest works, here are some common terms you might come across:

• Capitalizing: This is a common term that applies to student loans. It’s when a lender adds your unpaid interest costs to your loan balance (such as after a period of deferment.)
• Accrual: This term describes the interest you earn, but it hasn’t been paid out yet. So, an investment can accrue interest daily, but it is only added to the loan on specific payment dates (monthly, bi-annually, etc.)
• Compounding: Compounding is when you get an interest payment (or an interest charge) on your original balance plus any interest you’ve already earned or accrued.

Compound interest can have a positive effect on your finances if it applies to your savings or investments, but a negative impact if it applies to your debt.

Impact on loans

Car loans, mortgages, HELOCs, and student loans typically use simple interest, which means you only pay interest on your principal balance—not on accrued interest.

However, there are exceptions. For example, some private student loan lenders may use a compound interest formula. Students should know that unpaid interest during deferment or a grace period can be capitalized.

Personal loans may be calculated with compound interest. Before taking out a personal loan, check to see what type of interest the loan has and how the lender calculates it. A personal loan that uses a compound interest calculation can cause your balance to grow, costing you more overall than a simple interest loan.

To know which type of interest your loan has, I suggest asking the lender if the type of interest applied is not apparent. 

If you want to investigate on your own first, phrases that mean simple interest are “flat interest” or “calculated on principal only.” Phrases for compound interest include “interest added to the balance” or simply stating “compounding interest.” 

Definitely read the loan document, this will include which type of interest is applied to the loan and may have an example illustrated with the type of formula used.

Erin Kinkade, CFP®

Why hasn’t my loan balance decreased even though I’ve made payments?

This is a common question student loan borrowers ask if they are on an Income-Based Repayment (IBR) plan. With these plans, your student loan payment is capped at anywhere between 5% to 20% of your discretionary income. Here is an example to show why this type of plan might cause your balance to either stay the same or go up.

Example: A student graduates college with $30,000 of federal student loans at 6.5% interest and enrolls in an income-based repayment plan. Based on the graduate’s income, the IBR plan monthly payment is $150. However, a $30,000 student loan at 6.5% accrues $1,950.00 in interest annually or $162.50 monthly.

That means when this graduate makes their $150 monthly payment, it isn’t enough to cover the full interest. Additionally, the payment doesn’t pay down the principal either. As a result, this borrower can make years of on-time student loan payments but still end up owing more than they borrowed.

Impact on credit

You won’t accrue interest if you pay off your credit card balances in full each month. However, if you carry a balance on your credit cards and only make the minimum monthly payment, the interest compounds and can make it hard to pay down your debt.

Here is an example: If you have a balance of $10,000 on your credit card that accrues 22% interest (compounded monthly,) you’ll accrue approximately $183.00 in interest each month. If you only make the minimum payment of 2% of the total balance ($200), you’ll only pay off $17 of the principal.

If this continues each month for a year, where you only make the minimum payment each month, you’ll make approximately $2,400.00 in payments for the year, but your total balance will only go down about $200. That’s why paying more than the minimum each month on your credit cards, preferably your full balance, is important.

Impact on savings

Albert Einstein allegedly called compound interest the “8th Wonder of the World” because compound interest can increase your assets dramatically over time when saving and investing your money. Here is an example that illustrates how compound interest can positively impact your savings.

Example: If you put $8,000.00 into an account that earns 5% interest annually and left it in the account for five years (without any additional contributions), your $8,000 would grow to just under $10,300 simply by keeping your money in the account and allowing compound interest to work.

Even better, if you took the same $8,000 and put it in the same account (earning 5% annually for five years) but added $100 each month, your balance would grow to around $17,000. You can use a compound interest calculator or the formula at the bottom of this article to see the impact of compound interest in different scenarios.

Is compound interest good or bad?

Compound interest is good when it helps your money grow, and it’s bad when it puts you further into debt.

For example, if you have investments that compound daily, your money will benefit from compound interest. However, if you have credit card debt compounding daily at a 22% APR, the national average compound interest makes your debt grow instead.

In sum, compound interest is a powerful tool for wealth-building, but it can be damaging if it compounds your debt balances further into the negative.

Should I take out a loan with compound interest?

Lenders calculate loans with compound and simple interest, and it’s better to take out a loan that uses simple interest.

Most student loans, including federal student loans, use simple interest. With compound interest, you would pay interest on your original balance plus any outstanding interest on your loan. That means you’d pay more overall for a compound-interest loan than a simple-interest loan.

Compound interest loans can be beneficial or manageable if it is a short-term loan that can be paid off as agreed and if it is “good” debt, such as a mortgage (that you potentially refinance when market conditions improve) or a student loan that is managed well through budgeting and paying more than the monthly minimum payment.

Erin Kinkade, CFP®

Compound interest loans can be beneficial or manageable if it is a short-term loan that can be paid off as agreed and if it is “good” debt, such as a mortgage (that you potentially refinance when market conditions improve) or a student loan that is managed well through budgeting and paying more than the monthly minimum payment.

What should I do if I already have a loan with compound interest?

If you have a compound interest loan, refinancing it to a simple interest loan might be a good idea. However, it depends on several factors, such as your interest rate, loan term, and credit history.

If you have good credit and a stable job history, you might be able to refinance your loan into a new one. However, this only makes sense if you save money on interest due to getting a lower interest rate or switching to a simple interest loan.

Calculating the total cost of your current compound interest loan and a new loan you’re considering can help you determine whether refinancing is more advantageous.

How to calculate compound interest

Here is how to calculate compound interest.

• Start with your principal (P): This is the original amount of money you start with. For example, if you decide to put $100 in the bank in a savings account, P = $100
• Calculate your interest rate (r): This is the annual interest rate your bank has promised to pay you. When calculating the interest rate, like 5%, write it as a decimal (0.05).
• Know when your interest compounds (n): Some banks compound interest monthly (12 times every year), whereas some calculate it annually (once a year).
• Know your term (t): T stands for term (or time) in the formula. This is the amount of years you want to invest your money.

Calculating compound interest

Here is the formula for compound interest using the terms above. (You can also use a calculator online.)

(A)nswer = P (1 + [r/n]) ^ nt

In the example above, if we wanted to find out how much interest we’d earn on $100, earning 5% over a term of 5 years compounding monthly, here are the values we’d put into the formula.

• P: The starting amount is $100
• r: The interest rate is 5% (or 0.05) 
• n: 12 because the money compounds monthly (12x per year), with the initial investment occurring on January 1.
• t: 5 because the term is five years.

If we put those numbers into the formula, the formula would look like this:

A = 100 (1 + [0.05/12]) ^ 12×5

A = $128.34

That means that your $100 would grow to $128.34 over five years if your money compounds monthly. You earn more interest, and the more frequently your money compounds. So, you’d earn more if your money compounds daily and less if your money compounds annually. For daily compounding, use n = 365, and for annual compounding, use n = 1.

When investing and saving, the more frequent the compounding the better since this results in greater growth and the same impact happens with loans, the more frequent the compounding, the greater the loan amount. 

When given the choice for savings and investing, you will want daily compounding, but it ultimately depends on the type of savings/investment vehicle and with loans look for lower compounding frequencies (i.e. annually) or simple interest loans.

Erin Kinkade, CFP®

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