Compound interest is the eighth wonder of the world. Whoever understands it, deserves it. Whoever doesn’t, pays for it.
This saying, which some attribute to Albert Einstein, perfectly describes compound interest.
What is compound interest? If you have a savings or investment account, that’s money you earn from your interest. This is a good thing.
If your loan has compound interest, interest is charged on your interest. This is a bad thing.
Let’s take a closer look at compound interest in a savings account. Suppose you have a savings account of $ 1,000 and you earn 6% APY, which is a percentage of annual return. With simple interest, you would only earn $ 60 on your $ 1,000 in a year. But because of the compound interest, you earn more.
Let’s break it down. Each month, your account earns 0.5% interest, or $ 5. So at the end of the first month you have $ 1,005 in your account. So the next month, when you earn 0.5% interest, you earn it on $ 1,005, which is $ 5.025 (we’ll round it off to $ 5.03) instead of $ 5. Due to the compound interest, you have already earned an additional three cents. Your new balance is $ 1,010.03, which earns you $ 5.05 in interest. You picked up an additional two cents for a new balance of $ 1,015.08. Over time, those pennies add up and you earn more and more. This is why we say to start saving for retirement when you are young, because over a period of 40 years, the compound interest really adds up.
Now let’s take a look at the dark side of compound interest. Let’s say you have a balance of $ 5,000 on a compound interest loan, and it has an APR of 15% – that’s the annual percentage rate – and it compounds daily. If you wait 30 days for your first payment, your balance will already be $ 5,063.70. This means that even if you made payments of $ 63.70 each month, the outstanding balance would remain the same for the rest of your life.
As you can see, compound interest can be very expensive. That’s why so many finance gurus advise you to pay off your credit cards first if you’re trying to improve your finances. Auto loans and personal loans usually have straightforward, uncompounded interest, so there is a better deal. Mortgages have simple interest, but they require you to pay everything up front, so it takes a lot longer to pay off your principal. (The principal is the original amount you borrowed.)
Make sense ? Remember, compound interest on savings is good. But in a loan, it’s bad for your budget.