How Compound Interest Works

Compound interest is the magic money-making tool in savings that puts your money to work for you. Unfortunately, not many people understand how it works. On the surface, interest is money earned on money invested in savings. But there are two different ways of calculating interest, and that is where it gets a little murky.

Two Types of Interest-Bearing Accounts

Savings accounts are identified as either ‘simple’ interest or ‘compound’ interest, which denotes how the interest is calculated and earned. You will find variations of these accounts across many different types of financial products, including permanent insurance policies. Let’s look at how different types of interest-bearing investments make money.

What is Simple Interest?

One method of calculating interest is to calculate a fixed amount based on the original balance or principle in the account. For example, if you put $5,000 in a 2% simple-interest account, your end-of-year total will be $5,100 (or $5,000 Principle + (5,000 x .02) 2% Interest. With no further principal deposits, each subsequent year will add $100 in interest, regardless of the actual balance in your account, because you are only earning interest calculated on your principle of $5,000.

What is Compound Interest?

Compound interest is calculated using the principal balance in your account plus the accrued interest. Using compound interest, you’re earning money on the balance in your account rather than just the initial investment. So, in simpler terms–there’s more money to earn interest on, which means a greater interest-bearing potential over the life of your investment.

Your interest earnings are rolled into (or compounded) the principle at a set interval with compound interest. For example, an account that compounds interest annually will earn more interest in each subsequent year. If you open an account with a $5,000 initial deposit and a 2% compound interest rate, you will earn $100 in the first year. Then, the balance is compounded, and the following year, you will earn interest on $5,100 for a total of $102 in interest.

Why Compound Interest Accounts are a Smarter Choice

It should be simple enough to see the difference just by looking at the above examples. But you might be thinking that a few dollars aren’t really a big deal. So, let us look at how the differences add up over long-term investments.

In one scenario, you start putting money away in a compounding interest account early–at the age of 21. You faithfully add $200 per month until you reach the age of 30. Then, you stop contributing that $200 and put it towards raising a family or saving for your kid’s college instead. Meanwhile, you let your money sit and compound interest.

You contributed a total of $21,600 in moderately performing investments and retired at the age of 67 with 2.5 million. You also spent the bulk of your real adult years without being saddled with contributing your retirement month after month, and you still have a comfortable 2.5 million.

This scenario is how a permanent life insurance policy works. Buying a permanent life insurance policy when you are young lets you take advantage of lower rates and the magic of compound interest to grow your investment into a sizable return.

If you choose to forego these early investments, which is common for young adults who are not nearing retirement, you are only costing yourself money. Contributing the same amount per month to the same investments will require twice as much input with half the reward, just for waiting until age 30.

For example, starting at age 30 and adding $200 per month until age 67 is an investment of $91,200. You have already put in more than three times what your 21-year-old self would have contributed. What is more–when you retire, you will be lucky to see 1.5 million while the younger version of yourself who invested early beats your cash-out value by at least 1 million.

The Bottom Line

Compound interest is a smart investment choice all the way around. And, when you can put time on your side by investing early, it is a real money maker in the long term. Get started putting your money into smart investments like a life insurance policy today. Contact our team at PHP Agency to learn more about your investment options.