What is compounding interest, and a new tool to calculate it

Today, I'm proud to release the first of many upcoming tools to help you take control of your finance, a Compound interest calculator. As its name suggests, it's based on the magic of compounding interest. Before we go further, let me explain what that is. If you already know and understand the concept, you can skip the next paragraph and read the rest of the article to learn more about the calculator itself and how it can help you.

What is compound interest

So, back to the basic: what is compounding interest? First, it's important to understand what interest is meant in this context. Generally, interest represents payments from a borrower to a lender, so it's rather limited in scope. But when talking about compounding interest, a much looser definition of interest is implied. Compounding interest can be applied to gain on the stock market (which means both dividend and appreciation). It can even be applied to early raises on your salary within your career. So in this context, you can think of interest as any way you can increase a set amount of money, without having to add more of it yourself. In other words, growing your money. This takes care of the "interest" part within "compound interest".

What does it mean to compound your interest? I find it easiest to compare it to the opposite scenario, simple interest. In a simple interest scenario, you gain a set interest rate back at a fixed frequency. For example, if you get a government bond paying 2% annually and the bond itself costs $100, you will receive $2 every year until the bond expires. The interest is fixed, and you will receive $2 for you to decide what to do with it every single year. Let's examine another situation where you open a high-interest savings account with an online bank and put $100 in it. The bank will pay you 2% interest annually on the amount within your savings account, and the promo is good for 10 years. So the first year, your savings account will grow to $102. Now, let's examine what happens in the second year. Because your savings account now has $102 in it, you will receive $2.04 in interest, for a total of $104.04. In this case, you got 4 cents more, wow! While this looks small, the bigger the interest rate and the bigger the amount of time available to compound, the bigger impact on your wealth it will have.

Let's look at another example, a more realistic one. Let's say you invest in a balanced and diversified portfolio of stocks/bonds. Historically, such a portfolio would return an average of 7% per year, so how does it do after 10 years?

Important to note, this is just an estimate based on past performance, which means nothing of this is set in stone. But it can still be useful to help in planning.

So assuming you start with $100, you would end up with $196.73 after 10 years, for a gain of $96.73. With simple interest, you would have gain 10 * $7 = 70$. That's an increase of $26.73, or 38% more. How is that possible? Because the interest compounded of course!

How to use the calculator

Now that we're all on the same page and you know what compound interest is, time to try it out! You can set your own savings, interest rate and number of years. The calculator is included here so you can try it out quickly, but it's also available should you need to refer to it in the future. There's a link available within the tools sections of this website.

You can use it to plan what your finances will look like in the future based on where you are right now. Do you have enough money set aside for your retirement? Will it allow you to sustain yourself in the future, or do you need to continue saving? Even with an estimated interest rate, simulating the future will help you build a plan and gain confidence in it.

This is the first of many tools that are going to become available to you. From planning your retirement to saving up for a big-ticket purchase, these tools are meant to empower you into taking your financial future into your own hands. This calculator, as well as future tools, are provided as-is and free of charge in the hope that they may help you. If you like them, follow us on Twitter, Pinterest, or through our RSS feed to stay updated as we add new ones.