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Interest is money earned or owed on top of an initial investment at a regular rate. For instance, banks will regularly pay you a percentage of what you’ve deposited into your account with them, or money owed from a loan will increase over time.
While many people know that interest builds up in their bank accounts or on their car loans, they might not know that each of these accounts is affected by one of two different types of interest: simple and compound.
Compound interest works differently from simple interest, as it’s exponential, not linear. It’s best to think of compound interest as “interest on interest.” In other words, each time interest is calculated, it’s based on the principal amount invested and all the interest earned up to that point.
Compound interest is a crucial financial literacy concept to understand if you want to save money effectively and stay on top of your bills and debt. Read on for a detailed explanation for how compound interest works and how it can affect you in your everyday life.
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How Compound Interest Works
Understanding how compound interest can affect you both negatively and positively is vital to sound financial management. While—with a little bit of time and patience—you can leverage compound interest to work to your advantage, it also has the potential to send you into crippling, unpayable debt.
The initial amount loaned or deposited into an account is known as the principal. Simple interest is based solely on the principal, and the rate will stay consistent regardless of how your money grows.
As an example, if you took out a $10,000 car loan with 10% simple interest, the amount you owe would increase by $1,000 each time interest is calculated.
As an example, say you instead deposited that $10,000 into a savings account with 10% compounded interest. The first time interest is calculated, you would earn $1,000—bringing you to $11,000.
The next time your interest compounds, it is based on your current balance, and you would earn $1,100.
This process repeats based on your new total of $12,100—earning you $1,210—and so on. Like a snowball rolling down a hill, compound interest grows a little bit more each time it is calculated.
Since compound interest can apply to both your earnings in the bank as well as your credit card debt, it can be a blessing and a curse.
The following table shows how much money you could wind up with, depending on how many years you continue to save:
Invest $100 a Month for This Many Years
Using Compound Interest to Your Advantage
The easiest way to take advantage of compound interest is to find a bank or credit union that offers reasonable interest rates. Regular old checking and savings accounts have small interest rates, typically around .03% and .06%, respectively.
However, financial institutions also offer other ways of storing and saving money with interest rates well over the national average.
Money Market Accounts
A Money Market Account (MMA) is very similar to a savings account. It has withdrawal and transfer limits, a higher minimum balance, and a slightly higher interest rate than a checking account.
However, they are a bit more flexible than a checking account and offer the same features, like checks, ATM withdrawals, and a debit card. MMAs are suitable for people looking for flexibility and who want to receive a higher interest rate than a checking account.
Virtually every bank or credit union offers MMAs.
Certificates of Deposit
Certificates of Deposit (CDs) are another way of saving money offered by all banks and credit unions. Unlike checking, savings, or money market accounts, they do not provide the freedom to deposit or withdraw money at will.
A CD allows you to earn a high interest rate on a principal deposit by agreeing to let it sit for a predetermined amount of time, anywhere from six months to five years or even longer.
The interest rate on a certificate of deposit is fixed, which means the bank will not adjust it for the duration of the CD, and it can often be two to three times the national interest average.
Individual Retirement Accounts
Individual Retirement Accounts (IRAs) allow you to save money for retirement by making regular deposits to an account, earning compound interest.
There are two types of IRA options available from financial institutions:
- Traditional IRA. Your contributions to the account are tax-deductible. Once you withdraw the savings upon retirement, if you fit into a new tax bracket, the savings will be taxed at a lower rate than they would have been pre-retirement.
- Roth IRA. Contributions to a Roth IRA come from your already-taxed income, so they are not tax-deductible. However, if you meet certain conditions upon retirement, you can withdraw the savings completely tax-free.
It’s important to remember that compound interest benefits the most from regular deposits of your own money. You will see your money grow from the interest alone, but any contributions of your own will help your savings increase even faster.
The Dangers of Compound Interest
It should be clear that there are considerable benefits to finding the best compound interest option for you and leveraging it to maximize your savings. But just as compound interest can be extremely helpful in growing financially, it can also totally cripple you.
Loans and Mortgages
Except for auto loans, which only accrue simple interest, high-risk personal loans and mortgages are affected by compounding interest. Even if you’re making the minimum payments due each month, you may not see your debt decrease.
Ensure that your loan term is as short as possible, and always make sure to make higher-than-minimum payments whenever possible. You’ll also want to keep a balanced credit score to get the lowest possible interest rates on your loans.
Credit Card Debt
Perhaps most dangerously, your credit card debt is also compounding. Credit cards usually come with the highest interest rates, and it is easy to accrue a crippling amount of debt.
You’ll want to make sure your payments are higher than the minimum. Additionally, while credit card payments are typically made monthly, it’s a great idea to pay in two-week intervals, ensuring you stay ahead of the monthly interest additions.
Compound interest may sound like a daunting financial term, but it’s a simple concept that everyone should try to understand. It should be clear now that compound interest can make or break you financially, whether you’re saving money or paying back a loan.
While this article only scratches the surface of compound interest as a concept, you should now be better equipped to make intelligent financial decisions and begin saving your hard-earned cash.
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