Compound interest is interest added to the principal of a deposit or loan so that the added interest also earns interest from then on. This addition of interest to the principal is called compounding. Understanding compounding interest is important so that you will know how to make use of this powerful concept in finance to work for you.
In short, compound interest is the interest an investor earns on his original investment plus all the interest earned on the interest that has accumulated over time.
Here are 10 things that you will need to know about compound interest.
1. Anyone can benefit from compound interest. Almost all investments will earn you compound interest, if you decide to leave your earnings in the account. For instance, if you leave your principal amount with the interest earned within your account and not touch it, the interest from the first year will become the principal amount when calculating interest for the second year. There is no need to become a wall street wizard or Harvard MBA to understand that.
2. Compound interest is a double-edged sword. Compounding interest is great if it is working for you. It will help you to earn interests on the accumulated interest. However, if it is working against you, compound interest will become a your worst enemy in accumulating wealth.
3. You want savings to compound as often as possible. The more times the compounding effect takes place per year, the better it would be. If you’re borrowing, just the opposite applies.
4. Time is on your side. The longer money compounds, the faster it grows. Money growing at 6 percent per year will double in about 12 years, but it will be worth four times as much in 24 years.
5. Time is not on your side. Credit cards and other open-ended accounts use compound interest against you. That’s why “minimum payments” are likely to keep you in debt forever.
6. Don’t let today’s low interest rates discourage you. It’s true that banks aren’t paying much on savings accounts. But many mutual funds average a higher return and have very low minimums and no sales charges. If you can’t apply a few dollars to savings, most debts (think home or credit cards) will allow you to add any amount to your payment.
7. It adds up faster than you think. If you were to save $5 per month, you’d earn 5 percent interest compounded each month and with that continually for 10 years you’d have put $600 into savings. But the account would be worth $776. And, even if you didn’t add a single dime, it would be worth more than $1,500 in another 15 years.
8. Compound interest can free you from credit cards. Suppose your interest rate is 14 percent and you add just $5 per month to your payment. In 10 years, you’ll avoid $1,315 in payments.
9. You don’t have to be rich to make compound interest work for you. The principal works the same whether you invested $100 or $100 million. The millionaire may have more investment options, but even the poorest among us can use compound interest to reduce the amount that we pay credit-card companies and payday lenders.
10. Compound interest requires you to sacrifice today to reap a benefit tomorrow. It’s true that you’ll need to do something to save a few dollars today. But, it’s certain that the future reward will be greater than the sacrifice.