Compound interest is a common term in the world of personal finance and investing. This is an important concept to grasp because it can work in your favor or against you. I’ll walk you through everything you need to know about calculating compound interest, why it’s important, and how it can help.
What is compound interest?
The most complete way to explain this term is that it is interest calculated on both principal and interest accrued from previous periods for a loan or deposit.
A simpler way of thinking is that all interest is added on top of the starting amount. So the next time the interest is calculated, it is on a larger amount.
Sometimes we talk about interest-bearing interests.
It may not seem particularly large, but the cumulative effect over time as interest accumulates can be quite astonishing. This is why the effects of compound interest are sometimes even described as “magic”.
Calculation of compound interest
While the effects may seem magical, I can assure you that the compound interest calculation uses a simple mathematical formula.
If you love math, you can find the full equation online. If you’re like me and want to keep things simple, you can use a compound interest calculator. There are plenty of them on the internet. You have just entered the required variables and they will then give you a breakdown of how interest can be compounded over time.
What types of accounts can benefit from it?
The two main types of accounts that can benefit from the effects of compound interest are investment accounts and savings accounts.
The power of compound interest works best over a long period of time, and ideally with a high interest rate. For these reasons, you will often hear about compound interest in connection with investing. It should be noted that you need to reinvest any earnings for compounding to work.
Although interest rates on savings accounts may be lower than those on investment accounts, they can still benefit. It is always important to ensure that any interest earned is left in the account.
How to profit from compound interest
Imagine for a moment that your savings or investment account is a snowball. Every time it turns around and more snow (interest) is added, it grows bigger and attracts more snow.
Using compound interest to your advantage will accelerate the growth of your savings or investments and help you reach your financial goals faster.
The key factor that allows savings to flourish using this approach is time. The longer you can let the money in an account grow and let the snowball roll, the greater the cumulative effect will be.
How Compound Interest Can Work Against You
The less exciting side to this concept is that it can really work against you both when it comes to investing and debt.
When you invest, compound interest may also apply to any fees or costs associated with your account. Over time, these costs turn out to be much more than what at first might seem like a small percentage.
This is because you are effectively losing any potential gains from these costs, which eats away at your investments. This is why it is really important to use one of the best stock trading accounts with low fees or a top-rated ISA actions and actions to help you keep costs down.
The lesser-known downside of compound interest applies to credit cards and loans. When you borrow money, there is usually an agreed percentage of interest that you pay back on top of the original loan.
This means that your debts can also have a cumulative effect over time. In order to avoid falling into this spiral of debt, it is really important to try and use a 0% credit card.
If you already have credit card debt, you may want to upgrade to credit card balance transfer with a lower interest rate.
To take with
Compound interest can be an extremely useful tool for building wealth, but it can also significantly slow your progress.
To mitigate the negative effects:
- Keep your fees as low as possible when you invest
- Try to get the lowest possible interest rate when you borrow
To build wealth, a higher interest rate and a longer period will allow you to reap the most rewards.
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