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Compound interest is a term you’ve probably heard of, but understanding how it works can save you in the long run.
A study that examined information from S & P’s Global Financial Literacy Survey found that “Consumers who do not understand the concept of interest mix spend more on transaction fees, incur more debt and incur higher interest rates. higher on loans “.
Whether you regularly use a credit card or save money in a high-yield savings account, it’s important to note that interest is compounded, which means what you owe or earn may be. accumulate quickly.
Below, CNBC Select breaks down the difference between simple interest and compound interest, how the latter works, and the ways you can benefit from understanding compound interest.
Simple interest vs compound interest
Simple interest is calculated based on the original amount you borrowed or what you have in the bank. This is called your “principal”. Simple interest charges a fixed rate, which means that the interest stays the same for the life of the loan or account.
Compound interest, however, is calculated on your principal plus your accrued interest. This rate is variable and can change at any time. It basically pays interest in addition to interest.
Compound interest can work against you or in your favor, depending on whether you are borrowing or saving money. Below, we take a look at how much you could end up paying and earning with compound interest.
How Compound Interest Works on Your Credit Card
Let’s take a look at a hypothetical example of how compound interest can work against you.
Using 5, 10 and 15 year timeframes, we can see the effect of an interest rate of 16.61% (the average APR of credit cards according to the most recent data from the Federal Reserve) on a credit card balance of $ 6,194 (the average credit card debt of Americans). We have assumed that you only make the minimum payment.
As you can see in the table above, compound interest alone turns out to be quite expensive over time, so much so that it exceeds your initial balance after 10 years.
How Compound Interest Works in a Savings Account
If you put even a small amount of money into a savings account, compound interest can do the job for you and make your money grow exponentially faster than it would with interest. simple.
People often refer to compound interest as “money for making money”. To see how compound interest can make you money, let’s take the hypothetical example of depositing that same $ 6,194 into a high-yield savings account. We will use 1.21% as the interest rate, which is the current APY for Vio Bank High Yield Online Savings Account and Varo Savings Account.
For this example, we’ll assume that you don’t make any monthly contributions or withdrawals and that interest is compounded daily.
Compound interest can make your savings grow faster. While you earn around $ 374.74 every five years with simple interest, you will earn interest on the new balance (principal + interest) when you have a compound interest account.
It is important to note the frequency of the composition because it can vary. Your interest can be compounded daily, monthly, quarterly, semi-annually or annually. The more frequent the compounding periods, the higher the interest amount and the faster your money will grow.
How to take advantage of compound interest
At the end of the line
Before opening a new credit card or savings account, be aware of the impact of compound interest on your debt or savings. Using the examples above, on the one hand, you pay $ 10,657 in interest only after 15 years, but if you put that same amount into a high yield savings account, you could earn $ 1,232.67 in interest in the same period of time.
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Editorial note: Any opinions, analysis, criticism or recommendations expressed in this article are the sole responsibility of the editorial staff of Select and have not been reviewed, endorsed or otherwise approved by any third party.