Compound interest happens when the interest earned over time is added to the principal. It is interest earned on money that was previously accumulated as interest. Basically, it is an interest on the interest that eventually results in exponential growth.
When calculating compound interest, it is essential to consider the number of compounding periods. Compound interest is one way to help you earn a higher return on your savings and investments, but it can be unfavorable for you when you’re paying interest on the loans you acquired.
The compounding period happens a year. And at that point, regular interest is added to the principal, and the interest starts accumulating against the combined amount.
The compounding method is the process to identify how the interest compounds. In a savings account, it means the earnings on your investment are retained so the value of the investment goes up whenever the bank pays the interest.
Wikipedia has the following definition of compound interest:
“Compound interest is interest accumulated from a principal sum and previously accumulated interest. It is the result of reinvesting or retaining interest that would otherwise be paid out, or of the accumulation of debts from a borrower.”
How does compound interest work?
To illustrate, let’s say you put $100 into your savings account with an interest rate of 5 percent. After the first year, the interest you acquire on the second year will be more than the year before because your account balance is now $105.
Even though you didn’t add money to your account, your earnings will increase. After that period, the interest compounds, and then on the next year you earn 5% of $105 which becomes $110.25. As the time passes, the value you invested in your account increases.
In any case that you decide to withdraw the interest in your account in its third year which has a value of $115.76, the value in your account will be down to $100 and the following year, you will only earn $5 again.
The Formula in Computing Compound Interest
Using a financial calculator can help you calculate the compound interest and by following this formula:
A = P(1 + [r/n])^nt
These are the variables in this calculation:
- A: the amount as the compound interest
- P: Principal, or the initial deposit
- r: annual interest rate in decimal form
- n: number of compounding periods per year (for example, 12 is for monthly and 52 is weekly compounding periods)
- t: time that your money compounds in years
How to make compound interest work for you
Here are some ways to make sure that compound interest works to your advantage:
Grow your savings
The longer you save money to your account and leave it there, the greater it will grow. For example, you save $100 a month at 5% interest then you leave your money untouched for 5 years, then you will now have $6,100 on your account.
Even if you did not add more money to your savings after that time, your account will still earn additional interest because of compounding.
Pay your debts – not just the minimum amount
If you pay off your debts and clear them, you are making compounding interest work in your favor. But if you pay just the minimum amount off your loans to your money lenders, it will cost you more and your balance will not grow. Even if the bank tells you just to pay the minimum amount, it is best for you to pay a large amount to minimize your lifetime interest costs.
Choose investments wisely
You should greatly consider the interest rate you’re getting on your savings. Before you invest your money in a bank, you have to make a comparison on how much interest you can gain from other banks. If your money is invested in the stocks, check how the market is performing. Do not immediately believe the promise of high returns.
Invest your money early
The sooner you invest your money, compound interest will be beneficial for you. Start investing in low-cost index funds which allows you to have a share of different companies.
Unfortunately, compound interest is not always your best ally. When you have debts, compound interest will work against your favor. Every month that you have an unpaid balance from your loans or credit card, you will not just owe the amount you are being charged but the unpaid interest you have acquired over time.
The secret to making compound interest work for you is to start saving early and reduce or pay off your debts completely. By understanding the important concepts of compound interest and how it will work to your advantage, there is no doubt that you will be able to control your financial health.
Interesting related article: “What does interest rate mean?”