What is compound interest and how does it work?

Interest is an important concept to understand when it comes to business banking. When you borrow money, you’re responsible for paying interest on your loan, line of credit, or outstanding credit card balances. However, when it comes to annual percentage yield (APY), you have the opportunity to earn money on your business checking balances—a.k.a. making your money work for you.

Compound interest can make your business checking account even more powerful, as it helps your money grow faster by earning interest on top of interest. It’s been reported that Albert Einstein considered compound interest the eighth wonder of the world, with an often disputed quote: “Those who understand compound interest earn it. Those who don’t pay it.”

What is compound interest?

Compound interest is interest earned on both the principal amount along with the accumulated interest from previous periods. This allows for your money to be multiplied at an accelerated rate. Compounding is one of the most useful concepts in finance and is the foundation of investing in products like savings plans and the stock market.

While compounding works in your favor in long-term investments, it can work against you when borrowing money. 

Examples of compound interest

To better understand the power of compound interest, let’s look at a simplified example. Say you deposit $1,000 into an interest-bearing account that offers 2.0% interest per year, compounded annually. After the first year—assuming you don’t add or remove money—your balance would be $1,020. 

In the second year, you’ll earn interest on a balance of $1,020, which means your earning potential is even higher. So, again assuming your balance stays intact, you’d have a balance of $1,040.40 after year two.

Although it doesn’t seem like much, after 20 years, your initial $1,000 investment could turn into $1,219.14, generating almost $220 in passive income. 

Compound interest is pretty common and is the basis of many financial products. For example, when continually investing in stocks or mutual funds, investors earn compound interest on invested returns. As these investments grow in value, the earned returns on gains compound over time.

CDs, 401(k), and IRA retirement plans also earn compound interest on contributions, allowing investors to accumulate more for retirement. The power of compound interest is also prevalent in high-yield business checking accounts.

Compound interest vs. simple interest

While simple interest and compound interest are two methods of earning interest on a principal amount, there is a difference between how they’re used for different financial products and debts.

Simple interest means you earn interest on the principal amount only. If the initial investment and interest rates do not change, the earned interest is always the same. Compound interest, on the other hand, is interest calculated on both the principal amount and any accumulated interest that has already been earned. This means that the interest earned in each compounding period is added to the principal amount, and the interest for the next period is calculated on the new total. As a result, compound interest grows faster than simple interest over time. 

Compounding interest, however, can work against you when taking out a loan because the repayment includes the principal amount along with a compounded interest rate. This is common with credit card debt, which is why it can feel that it grows so quickly.

Simple interest rates can be ideal for a loan or business line of credit because your repayments will be more predictable and consistent.

My wealth has come from a combination of living in America, some lucky genes, and compound interest.

– Warren Buffet

How compound interest is calculated

To better understand how compound interest is calculated, let’s take a closer look at different variables that can impact earnings using the compound interest formula:

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

A = the total amount of money including interest at the end of the investment period

P = the principal or starting balance

r = the interest rate (expressed as a decimal)

n = the number of times interest is compounded per year

t = the length of time the investment is held (in years)

If additional deposits or withdrawals are made during the investment period, they can be added or subtracted from the principal balance at the beginning of each compounding period, with the formula changing to: 

A = (P + D)(1 + r/n)^(nt) – W

D = the amount of deposit

W = the amount of withdrawal

The frequency of compounding is also an important variable that impacts earnings. The more frequently interest is compounded, the faster your investment can grow. 

For example, if interest is compounded monthly, n equals 12, and the formula would be:

A = P(1 + r/12)^(12t)

The power of compound interest

Compound interest is not only a powerful wealth accumulation tool for personal investments but for businesses as well. Below, we’ve outlined some tips for how to make compound interest work for your business.

1. Start sooner to maximize your time to earn

Time is money. The sooner you start saving or investing money, the more time your money has to grow. If you can find a business checking account that gives you the opportunity to earn high-yield interest on your operating balances, that’s an ideal solution.

2. Compare APYs when choosing a business checking account

Because APR (annual percentage rate) accounts for a simple interest rate, it’s better to focus on APY (annual percentage yield) to get a clear picture of what your compounded interest earnings could be.

3. Understand how frequently your account compounds interest

Frequency is king when it comes to compounded interest. The higher the frequency, the more money you can earn. While it’s recommended to select savings products that compound more often, less frequency is desirable for debt.

4. Pay off debt ASAP

This is especially important for debts whose interest is compounding. When taking out business loans, compound interest can make it difficult to pay down the debt, so you’ll want to pay them off as soon as you can.

Compound interest can be a double-edged sword, and it’s important to understand how it works to use it to your small business’ advantage. While compounding interest is a great tool to grow long-term investments, it can have a negative impact when taking on debt. Do your due diligence and choose the right financial products to help your business achieve its financial goals.