The Wonders of Compound Interest

Last Updated on May 23, 2023

At some point in these recent times, you must have seen or heard something about “growing your money” with compound interest. The truth, however, is that compound interest is not a new thing in the finance industry, it has always been. Even with this fact, not a lot of people know about it, so here are some facts about compound interest that you should know about.

Before moving into facts about compound interest you should know about it. Let us get a back story for better understanding.

What Is Compound Interest?

Compound interest makes a return on the money invested plus a return on those returns at the end of each compounding period—daily, monthly, quarterly, or yearly—so the total money grows faster than simple interest. This is why compound interest makes your wealth grow faster. This is also why you don’t need to set aside that much money to reach your goals.

Compound interest is more than just paying interest on the principal balance. Your interest will also be of interest. Compounding means adding the interest you earn to your principal balance, earning more interest, and compounding your earnings.

Suppose you have $1,000 in a savings account with an annual interest rate of 5%. Earn $50 in the first year and have a new balance of $1,050. In the second year, you will earn 5% of the larger balance of $1,050 (which equals $52.50), and at the end of the second year, you will have a new balance of $1,102.50.

Thanks to the magic of compound interest, the growth of your savings account balance accelerate over time as you earn interest as your balance grows. If you leave $1,000 in this hypothetical savings account for 30 years, earn 5% annual interest all the time, and never add a dime to the account, the balance will be $4,321.94. Interest can be compounded or added to equity at various time intervals. For example, interest can be compounded annually, monthly, daily, or even continuously. The more often the interest is compounded, the faster the equity balance grows. Make use of the chart from NerdWallet, they would tell, how much you’d need to put aside for a certain goal.

Understanding the compound interest factors

When calculating compound interest, you need to understand a few key factors. Each plays a unique role in the final product, and some variables can greatly affect returns. Here are five key variables to help you understand compound interest.

  • Interest: This is the interest you will earn or be charged. The higher the interest rate, the more money you make or borrow.

  • Start a principal: How much money do you start with? What was the debt you owed? Compound interest adds up over time, but it’s all based on the original amount you deposit or borrow.

  • Compound interest frequency: The compound interest rate, whether daily, monthly, or yearly, determines how quickly your balance grows. When you take out a loan or open a savings account, understand how often interest is compounded.

  • Interval: How long do you plan to keep the account or pay off the loan? and earn more money.

  • Deposits and withdrawals: Do you expect your account to be credited regularly? How often do you make loan payments? The pace at which you build your capital balance and pay off your loan will make a big difference in the long run.

Read: How to Create a Budget for Your New Business

Examples of Compound Interest

Some other facts about compound interest are how it can help or hurt you depending on whether you are saving or borrowing money.

  • Savings account, checking account, certificate of deposit (CDs): When you deposit money into a bank account that pays interest, such as a savings account, the interest is credited to your account and added to your balance. This will increase your balance over time.

  • 401(k) Accounts and Investment Accounts: 401(k) and investment account earnings also add up over time. Daily stock gains are calculated based on the previous day’s performance. You can grow your bankroll even faster by reinvesting your dividends and making regular deposits.

  • Student loans, mortgages, and other personal loans: Compound interest works against you when you borrow. When you borrow money, you accrue interest on any money you don’t pay back. If you don’t pay the interest charges within the period stated in your loan, they’re “capitalized,” or added to your initial loan balance. After that, future interest accrues on the new, larger loan balance. Calculate how much your interest will add up to (and how much extra payments can save you) with our student loan calculator.

  • Credit cards: Credit cards charge interest on the balance on the card each month. If you do not make any other charges to your card and pay the accrued interest monthly, your balance will remain the same. However, if you don’t have enough payments to cover the new interest for the month, they will be credited to your credit card balance. The next month’s interest is then calculated based on that higher amount. Over time, this can cause your balance to skyrocket.

How to make it work for you

I guess the main reason why compound interest has become a trendy topic in the world of finance is because of how they have been stated facts about compound interest that have given the impression that it can work for you. Now, how do you make compound interest work for you?

  • Give yourself time: In compound interest, the power of time is everything. The sooner you start saving and investing, the longer you can grow that money. That’s why it’s important to start saving for retirement as early as possible. The sooner you start, the less money you have to save yourself. Most of your retirement savings can grow with compound interest.

  • Aggressively pay off debt: Compound interest works against you when you borrow money, whether it’s student loans, credit cards, or any other form of borrowing. The sooner these are repaid, the less money you can borrow over time.

  • Compare APY: The percentage annual return (APY) gives you a better idea of what you’re making and what you’re paying in interest than the annual percentage rate (APR). This is because APR is simple interest while APY considers compound interest.

  • Check the compound rate: The more often your account earns interest, the more profit you can make. (Or you owe more.) Ideally, you want your savings product to earn interest as often as possible and borrow as little as possible.

Few fun facts about compound interest nobody will tell you about

1. Anyone can benefit from compound interest: You don’t have to be a Wall Street wizard or a Harvard MBA. Almost all investments are compounded as long as you keep the income in your account.

2. Compound interest is a double-edged sword: saving money regularly is great, but borrowing money is cruel.

3. You want to compound your savings quickly; Quarterly compounding is better than annual compounding when it comes to saving money. The opposite is true for borrowing.

4. Time is your friend: The longer the money earns interest, the faster it grows. Money growing at 6% a year doubles in about 12 years but quadruples in 24 years.

5. Time is not on your side: Credit cards and other open accounts use compound interest against you. Because of this, “minimum payments” can leave you in debt forever.

6. Don’t be discouraged by today’s low-interest rates. It’s true that banks don’t keep much money in savings accounts. However, many mutual funds have higher returns on average, very low minimums, and no sales fees. If you can’t save a few bucks, most debts (think home or credit card) allow you to add any amount you want to your payment.

7. It will add up faster than you think. If you save $5 each month, you’ll earn 5% interest each month and save $600 over 10 years. However, the account is now worth $776. It’s worth over $1,500 in 15 years without adding a cent.

8. Suppose the compounded interest released from your credit card is 14% and only $5 is added each month. You can avoid paying $1,315 over 10 years.

9. You don’t have to be rich for compound interest to work. The principle works the same regardless of whether you invest $100 million or $100 million. Billionaires may have more investment options, but even the poorest of us can use compound interest to pay less to credit card companies and payday lenders.

10. Compound interest requires you to make sacrifices today to benefit tomorrow. It’s true that something has to be done today to save a few bucks. But it is certain that the future rewards will outweigh the sacrifices.

Before you go…

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