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What is compound interest? Understanding this financial term can save you thousands of dollars over time

CNBC Select defines compound interest, how it works and ways to take advantage of it if you're looking for a new credit card or somewhere to stash your cash.

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Editor's Note: APYs listed in this article are up-to-date as of the time of publication. They may fluctuate (up or down) as the Fed rate changes. Select will update as changes are made public.

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Compound interest is a term you've probably heard of, but understanding just how it works can save you in the long run.

A study that looked at insights from the S&P's Global Financial Literacy Survey found that "consumers who fail to understand the concept of interest compounding spend more on transaction fees, run up bigger debts and incur higher interest rates on loans."

Whether you regularly use a credit card or you save money in a high-yield savings account, it's important to note that the interest is compounded — meaning what you owe or earn can add up quickly.

Below, CNBC Select breaks down the difference between simple and compound interest, how the latter works and ways you can benefit from understanding compound interest.

Simple interest vs. compound interest

Simple interest is calculated based on the original amount you borrowed or what you have in the bank. This is called your "principal." Simple interest applies a fixed rate, meaning that the interest remains the same for the lifetime of the loan or account.

Compound interest, however, is calculated on your principal amount, plus your accumulated interest. This rate is variable and can change at any time. It essentially pays interest on top of interest.

Compound interest can either work against you or in your favor, depending if you're borrowing or saving money. Below, we review how much you could end up paying and earning with compound interest.

How compound interest works on your credit card

Let's take a look at a hypothetical example of how compound interest can work against you.

Using 5-, 10- and 15-year timelines, we can see the effect of a 16.61% interest rate (the average credit card APR by the Federal Reserve's most recent data) on a $6,194 credit card balance (Americans' average credit card debt). We've assumed that you're only making the minimum payment.

Total credit card balance Interest accumulated
Principal amount$6,194$0
After 5 years$9,158$2,964
After 10 years$15,698$6,540
After 15 years$26,355$10,657

As you can see in the table above, the compounded interest alone adds up to be quite expensive over time — so much that it surpasses your initial balance after 10 years.

How compound interest works in a savings account

If you deposit even a small amount of money into a savings account, compounded interest can do the work for you and make your money grow exponentially faster than it would earning simple interest.

People often refer to compound interest as "money making money." To see how compound interest can make you money, let's take the hypothetical example of depositing that same $6,194 into a high-yield savings account. We'll use 1.10% and 1.20% as the interest rate, which is the current APY respectively for the Vio Bank High Yield Online Savings Account and Varo Savings Account.

For this example, we assume you're making no monthly contributions or withdrawals and the interest is compounded daily.

Using simple interest Using compound interest
Principal amount$6,194$6,194
Savings after 5 years earning 1.21% interest$6,568.74$6,580.30
Interest accumulated$374.74$386.30
Savings after 10 years earning 1.21% interest$6,943.47$6,990.69
Additional interest accumulated$374.73$410.39
Savings after 15 years earning 1.21% interest$7,318.21$7,426.67
Additional interest accumulated$374.74$435.98
Total interest accumulated after 15 years$1,124.21$1,232.67

Compound interest can make your savings grow faster. While you earn approximately $374.74 every five years with simple interest, you'll earn interest on the new balance (principal + interest) when you have an account with compound interest.

It's important to note the frequency of compounding as it can vary. Your interest could be compounded daily, monthly, quarterly, semiannually or annually. The more frequent compounding periods, the greater amount of interest and the faster your money grows. 

How to take advantage of compounding interest

Once you know how compound interest can harm or help you, it's important to take action so you can benefit from it.

If you are looking to open a new credit card, consider cards with an introductory interest-free period so that you avoid racking up high compound interest if you happen to carry a balance. 

CNBC Select ranked the best intro APR credit cards to finance debt or new purchases from account opening, and a handful of our top picks are below:

  1. For 21 months: on purchases and qualifying balance transfers -Wells Fargo Reflect® Card (18.24%, 24.74%, or 29.99% variable APR thereafter; see rates and fees). Balance transfers made within 120 days from account opening qualify for the introductory rate. Balance transfer fee (5%, $5 min) applies
  2. For 18 months: on balance transfers- Citi Double Cash® Card (19.24% - 29.24% APR variable thereafter) Balance transfers must be completed within 4 months of account opening. There is an intro balance transfer fee of 3% of each transfer (minimum $5) completed within the first 4 months of account opening. After that, your fee will be 5% of each transfer (minimum $5; see rates and fees).
  3. For 15 months: on purchases and balance transfers- Capital One SavorOne Cash Rewards Credit Card (19.99% to 29.99% APR variable) or Chase Freedom Flex® (20.49% - 29.24% APR variable thereafter)

And for those interested in letting their money grow in a savings account, we recommend high-yield savings accounts that can earn you 16X more money than a traditional savings account.

CNBC Select ranked the best high-yield savings accounts, and below are our top five:

  1. Best overall: Marcus by Goldman Sachs High Yield Online Savings
  2. Best for checking/savings combo: Ally Online Savings Account
  3. Best for easy access to your cash: Synchrony Bank High Yield Savings
  4. Best for earning a high APY: Vio Bank High Yield Online Savings Account
  5. Best if you want extra help saving: Varo Savings Account

Bottom line

Before you open a new credit card or a savings account, be aware of how compounding interest can impact your debt or savings. Using the examples above, on one hand you're getting charged $10,657 in interest alone after 15 years, but if you put that same amount into a high-yield savings account, you could make $1,232.67 in interest in the same amount of time.

Information about the Chase Freedom Flex® and Synchrony Bank High Yield Savings has been collected independently by Select and has not been reviewed or provided by the issuer of the card prior to publication.

Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.
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