### What is compound interest and how does it affect you?

Welcome to *What’s That Mean, Anyway?* — our column explaining financial terms and concepts in a way you can actually understand.

Seems odd, right? A financial company explaining financial terms in a way you can **actually** understand. Finance is filled with so much jargon it’s like trying to jump into a conversation without knowing the language.

Today’s topic is both good and bad for you — **compound interest.**

#### What’s That Mean, Anyway?

Okay, so first to understand compound interest, you need to know what interest is. Also, as a warning, there’s going to be some math.

*Ugghh math, but I’m listening.*

So interest represents the cost of borrowing money, and it’s usually expressed as a percentage rate. You hear about it most often when talking about loans or watching credit card commercials.

*Wait, but I have an interest rate on my savings accounts, and I didn’t borrow that money from my bank.*

Well, the bank is actually borrowing that money from you. While your money is in your savings account the bank is using it to fund boring banking things, and as a thank you, they technically pay you.

*Oh, that’s great.*

Yep. So there are 2 ways people calculate interest — simple and compound. Simple is pretty, well … simple. And because that wasn’t your question, we’re going to skip right to compound interest.

*Hooray! Less math.*

Just kidding. You walked right into that one. The easiest way to explain compound interest is by comparing it to simple interest. Which requires math, sorry.

*Okay fine. What’s the difference?*

Simple interest is calculated from the original loan amount. Compound interest is calculated from the original loan amount **plus **the interest charged.

*So compound interest is kind of like “interest on interest.”*

Exactly.

*Now I’m interested. Bring on the math.*

Ha. “Interested.” Nice.

START OF MATH > So say you put $10,000 in that savings account you have, and your account has an interest rate of 5%. Then immediately after making your deposit you risked your life saving a bus full of puppies and orphans.

*That sounds like me.*

But although you saved all the orphans and puppies, you hit your head, fell into a coma for 3 years and couldn’t touch that savings account. Let’s see how much money you’d have in your account when you awoke 3 years later as a hero.

#### Simple Interest

Simple interest is calculated each year only on the original deposit.

Coma Year 1: $10,000 x 0.05 = $500 in interest + Coma Year 2: $10,000 x 0.05 = $500 in interest + Coma Year 3: $10,000 x 0.05 = $500 in interest

Total interest earned while in coma = $1,500

So as the city throws you a parade when you wake up from your coma, with simple interest, your savings account will have $11,500 in it.

*Simple Interest Equation:*

[$10,000 x 0.05 x 3] + $10,000 = $11,500

#### Compound Interest

Compound interest is calculated each year by adding the interest onto the current total amount in the account.

Coma Year 1 = $10,000 x 0.05 = $500 in interest + Coma Year 2 = $10,500 x 0.05 = $525 in interest + Coma Year 3 = $11,025 x 0.05 = $551.25 in interest

Total interest earned while in coma = $1,576.25

So as the city throws you a parade when you wake up from your coma, with compound interest, your savings account will have $11,576.25 in it.

*Compound Interest Equation:*

[(end of year 1 in account) x (interest rate)] + (end of year 1 in account) = (end of year 2 in account)

[(end of year 2 in account) x (interest rate)] + (end of year 2 in account) = (end of year 3 in account) [(original deposit in account) x (interest rate)] + [(end of year 1 in account) x (interest rate)] + [(end of year 2 in account) x (interest rate)] + (original deposit in account) = (end of 3 three in account) [$10,000 x 0.05 x 3] + $10,000 = $10,500

[$10,500 x 0.05 x 3] + $10,500 = $11,025

[$11,025 x 0.05 x 3] + $11,025 = $11,576.25 [$10,000 x 0.05] + [$10,500 x 0.05] + [$11,025 x 0.05] + $10,000 = $11,576.25

< END OF MATH

*Wow. That was a lot of math.*

Yep, sorry. So with compound interest, you’d earn $76.25 more while you were recovering from your heroics than you would with simple interest.

*I’ll take that.*

And the math can get even more complicated if your interest isn’t calculated yearly — it can be calculated monthly, or, like most credit cards, daily. But do you get the baseline of what compound interest is?

*I think so. Compound interest is just the interest charged/earned over the life of a loan or deposit that takes into account the interest charged/earned before it.*

*Like if I took a bite out of an apple. My next bite out of that apple won’t be from the original unbitten apple — which is simple interest — it will be out of the apple I’ve already bitten. Compound interest takes into account what’s already happened and builds on it.*

That’s … actually a pretty good analogy. You kind of nailed it.

*Got it. Thanks. So that’s what that means.*