To get ahead in the world of finance, you should be familiar with compound interest. Simply put, compound interest is interest that accumulates. More specifically, compound interest is the extra money earned on the principal amount of your initial deposit, plus the interest that builds up over time.
Simple interest is its counterpart, which means that you only earn interest on the principal amount. You don’t make any additional money on interest. Typically, both simple and compound interest are expressed as percentages.
Compound interest adheres to “the snowball effect.” That is, once it begins, it just grows and grows. Depending on the context in which this is applicable, compound interest can be very advantageous, or it can be an immense detriment to your finances.
Read on as we further describe how compound interest works, real-life examples of compound interest, and how to calculate it.
How does compound interest work?
Starting at the beginning, you first must deposit your money into an account at the bank, which, in turn, will pay you interest on that deposit. It is up to you to decide how much money you want to deposit, though larger deposits typically earn more interest. In the time that follows, you will continually earn interest on your deposit, as well as earn interest on that interest.
It is a rapid process that occurs daily, but it does take some patience, and results will begin to show in a few months.
Again, compound interest can be both beneficial and detrimental. It all depends on what is happening with the money. If you are borrowing money instead of depositing it, then compound interest is most likely working against you.
Understanding the power of compound interest
Compound interest is a powerful phenomenon in the world of finance because of its repetitive nature. Essentially, compound interest is “money that makes money.” A bit of time is necessary for the interest to build, but once it does, it grows exponentially.
There are four main factors involved in this process.
One: Time. Compound interest turns into more significant amounts over lengthier periods. Again, give your money time to grow.
Two: Frequency. The more frequent the compounding periods, the more significant the results. These vary between financial institutions. Interest can increase daily, monthly, or annually. Bank accounts that offer daily compounding interest are the best way to go.
Three: Interest rate. Higher interest rates mean you’ll make more money faster. But regardless of the rate, compound interest will always increase.
Four: Deposits. Adding more to your bank account will see that the interest accumulates. If you continually make withdrawals, you won’t earn as much.
Real life examples of compound interest
Described below are a few of the most notable examples of compound interest in real life.
One: Your savings. If you choose to open a savings account that earns you interest, your total balance will grow.
Two: Both 401k retirement plans and investments, such as stocks, earn money this way. Specifically, this is especially true for the latter, as stocks are dependent on their daily performances.
Three: Loans. This category includes mortgages, student loans, and car loans. Any money you don't pay back accumulates interest, which, in turn, requires even more time to pay off the loan in full.
Four: Credit cards. You pay interest according to your approved credit limit, which can result in debt if you are not careful. Any interest fees you cannot pay on your monthly balance roll over and spiral upward from there.
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Compound interest versus simple interest: Are they the same?
No, simple interest and compound interest are not the same. Simple interest means you pay a fixed interest fee on the original amount of your loan and nothing more. Specifically, this can also apply to loan payments such as personal loans and car loans.
Simple interest can be determined using the formula below.
Simple interest = P x i x n
P represents the principal amount, i is the interest rate, and n is the duration of the loan.
How to calculate compound interest over time
You can calculate compound interest rates in a few different ways. The first is using the formula described below, which involves the same variables found in the simple interest formula.
A = P (1 + [r]n]) nt
A is the result or the compound interest rate. P is the principal amount, r is the annual interest rate, n is the number of compounding periods each year, and t is the amount of time in years that your money compounds.
Online calculation platforms are available for you to use as well. The federal government has a platform that can help you with that, which you can find here. Finally, software programs such as Google Spreadsheet and Microsoft Excel let you calculate compound interest as well.
Like many financial concepts, compound interest is a double-sided coin. If handled strategically, compound interest can be beneficial, but if overlooked or disregarded, it can become a severe disadvantage and cause you to spiral into debt quickly.
Before deciding to put your money toward anything, be it a loan or into a savings account, always be sure to do your research so that you can pick the option that is best for you and your financial future.
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