Compound interest can either be your friend or your enemy. If you have a credit card with a revolving balance then compound interest is not your friend; it is working against you. However, if you have an investment account such as a 401(k) or an IRA then compound interest is your friend.
What Is Compound Interest?
Compound interest (or compounding interest) is interest calculated on the initial principal and which also includes all of the accumulated interest of previous periods of a deposit or loan, or in other words, interest on interest.
For an investment, you earn interest on the money you deposit, and on the interest you have already earned – so you earn interest on your interest.
How Does Compound Interest Work?
There are two ways to show interest; simple interest and compound interest.
With simple interest, interest is earned on the principal.
For example, if you had a $10,000 deposit (or loan) and you earned 5% a year, then ever year, you would earn (or pay) $500.
Compound interest works differently than simple interest. Compound interest lets you earn interest on your interest.
If you take the same example with the $10,000 deposit, at the same 5% interest rates, then at the end of the year, you would have $10,500.
In the second year, you are going to earn the same 5%, but now you will earn it on $10,500 instead of the original $10,000 that you invested.
After the second year you will have $11,025.
It may not seem like a huge different at this point, but the longer the investment can earn compound interest, the more you are going to earn.
Using Compound Interest In Your Favor
Your objective should be to make compound interest work in your favor.
There are lots of investment products that provide you with an opportunity to earn compound interest, and if you make regular contributions to these accounts you can build up your nest egg to a very large amount, depending on the length of your investment period. While a one-time lump sum deposit or investment using compound interest will still earn money, you can build your wealth more effectively if you make regular contributions to your account.
Its really a no-brainer. The sooner you start, the richer you can become.
How Finance Companies Make Money
While you can used compound interest in your favor, be mindful that companies that lend money are also using compound interest to benefit too.
When you take out a loan you are charged interest on the amount you borrow.
Interest is the fee you pay in order to borrow money. Lenders want to make money off of the money they provide to you, so they charge interest. The higher the interest rate charged, the greater the profit and the more money you are putting into the lenders pocket. Needless to say, you should avoid paying high interest rates.
You should also attempt to pay off a loan as early as possible and avoid extended payback periods because this lengthens the time that lenders can charge you interest. In other words, the longer the period that interest can accrue, the more it will cost you in the long run.
For example, when you have a credit card with a revolving balance (a revolving balance is the portion of credit card spending that goes unpaid at the end of the billing period) you are making the credit card company a lot of money.
Credit card companies are smart and are well aware of the power of compound interest. This is why credit card companies compound interest daily. The more often interest is compounded, the more fees will compound, and thus will grow a little bigger each day. When interest is compounded, it is added to your outstanding balance. Then, the next time interest is charged, you are charged on the principal amount outstanding, plus the interest that accrued because the balance was not paid off by the end of the billing period.
For example, Mike opens a credit card with a $1,000 credit limit and interest at 14.99% (many credit card charge interest higher than this). He makes a purchase of $200. Mike understands that he will pay interest on the amount borrowed until he pays it off, but for some reason Mike decides to carry a revolving balance and only pays the minimum payment of $20 each month. By only making the minimum payment of $20 per month, it will take Mike 11 months to pay off his balance. Instead of paying back only $200, he will have paid $216.72.
Final Thoughts On Compound Interest
Now that you understand the power of compound interest, hopefully you can see very clearly that compound interest can either be your friend or your enemy; it can either make you rich or keep you poor.
Ultimately, the decision is really up to you on how compound interest works for you. To create wealth, start using compound interest early to create a longer investment period for your deposit to grow. Alternatively, when you use credit, try to pay off the loan as quickly as possible.