What Is Compound Interest Used For?

David Hunter, CFA, M.E.C.:

Compound interest (or the compounding of returns more broadly) is a foundational principle for savings, investing and financial planning. In the simplest terms, it can be described as the overall long-term return on an asset (whether it is cash in a savings account or a mutual fund in an IRA), not only being the initial rate of return on the initial value of that asset but also the return upon the gains or losses accrued by that asset over time. The end result is that the overall net gain on one’s savings or investments ends up being an aggregate of the return on the initial asset value and the “return on prior returns” gains.

In the specific case of compound interest, two examples would be the interest earned through savings and the interest paid on debt. In the case of savings, savers will earn interest on both the initial money saved and the interest accrued over time. In the context of debt, overall costs to the borrower pertain not only to the interest on the initial principal borrowed but also to the interest on the interest balance that accrues over time. For savers, lenders and investors, this means that time is not only an advantage but an exponential advantage. The longer the time horizon, the more interest-accumulating periods occur and the more interest compounds on itself, resulting in a much higher return than if interest had accrued purely on the initial asset value.

Melissa Weisz, CFA:

Compound interest is one of the most powerful tools in the financial toolkit, earning interest on your original investment plus interest on interest. This means your money has the potential to work for you. You may have heard the phrase "putting money to work" because, given time and the power of compounding, money can grow as compound interest begets more interest.

Compound earnings are fundamental to the financial planning process, and their uses are as varied and unique as our individual goals. You can use compound interest to accumulate assets for goals large and small, near-term and many years away. You may consider short- and intermediate-term goals like purchasing a home or taking a special vacation. Longer-term goals like retirement and college funding are great uses of compound interest, as earnings can compound and accumulate over time.

Using the Rule of 72, you can estimate how long it will take for an investment to double based on the rate of return you assume will be earned. For example, an investment earning 8% per year would double in approximately nine years. You can also work in reverse; if the goal is to double my investment in 10 years, for example, then I would need to earn approximately 7% per year.

Sean J. Britton, NRP:

When you borrow money, you are going to pay interest, and when you save or invest money, you are typically going to earn interest. Compound interest is the interest accumulated on the principal plus the interest. Over time, compounding causes an exponential growth of the total interest. In cases where you are earning interest, this is incredibly beneficial, and in cases where you are paying interest, this can make it very difficult to pay down debt.

Jake Heisler, CFP:

I'm always reminded of Einstein's quote about compound interest—he said, "Compound interest is the eighth wonder of the world." "He who understands it earns it; he who doesn't pays it."

Compound interest can be attributed to both positive and negative outcomes. In other words, compound interest can be a wealth creator or a wealth destroyer. In discussions with our clients, we often connect compound interest benefits with retirement savings, investment accounts or bank accounts. However, it could also be used to calculate mortgage payments, credit card debt and other loan payments.

Nicholas Ockenga, CFP®, AIF®, CBDA:

Compound interest is a beautiful thing. Even Einstein is quoted as saying, "Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn't pays it." Compound interest is most often discussed regarding savings and investment returns. It's used quite frequently in various charts and graphs to show what a given rate of return will yield you over a specific period of time.

One of the best ways to put this concept to use is through the rule of 72. This rule is easy to remember and a great strategy for making quick and easy back-of-the-envelope calculations on how your money might grow in the future. The rule is simple.

If you divide any number by 72, the answer will be either the rate of return you need for your money to double or the years it will take for your money to double.

The number you start with will represent either the required rate of return or the years it will take to double your investment. Here's an example: If you divide 72 by 10, you get an answer of 7.2. If 10 represents the rate of return you expect to receive, then 7.2 will be how many years it will take any investment to double based on an annual rate of 10%.

Or you can look at it the opposite way and say it will take a rate of 7.2% annually for your money to double in 10 years. Of course, compound interest applies to debt as well as investments. This is where you want to watch out for how much you could pay overtime on debt with an interest rate that is also compounding.

Tyron Draper, ChFC:

Compound interest is basically the interest that you earn on an investment or accrue on a debt instrument (typically a loan). Some basic uses of compound interest include interest-bearing savings accounts, stock market-based investments, auto and home loans and credit card debt. A positive effect of compound interest would be "interest earned on interest."

An example would be a 5% rate of return on a CD. The interest credited on $100 in a year would be $5. In the second year, the 5% rate of return would now be credited at $105 instead of $100. Conversely, a 5% interest rate on a credit card would charge the account holder $5 in interest on a $100 balance and 5% on $105 in the second year.

Colin Zizzi, CFP:

Compound interest is the concept of interest being earned on interest. From an investment standpoint, the interest earned on your investment accounts can begin to outpace the actual amount of contributions or principal of those investments over time.

The earlier you start investing, the greater the impact of compounding over your investment time horizon. As a former athlete, I also like to think of compounding as the small incremental actions we take that increase over time to make a task easier. For me, having spent thousands of hours as a kid juggling a soccer ball makes that a routine task that has become second nature.