When it comes to understanding your finances, there are a few things you just need to know. Understanding what compound interest is, is one of those must-know financial terms.
Compound interest can help you earn more when it comes to savings and investments you might have. However, on the flip side of the coin, it means you could also end up having to pay more when you pay interest on a loan.
But what exactly is compound interest, and what role can it play in my financial planning? In short, compound interest is interest calculated on the principal plus interest accumulated from previous periods.
Keep reading this article as we break down compound interest and what you need to know about it.
What Is Compound Interest?
Compound interest is when interest is calculated in which interest is earned and added to the principal. Over time, your interest will be included in the principal, and you will earn or be charged interest on the principal plus the earned interest. You can kind of think of it like the snowball effect, gathering and building on itself.
The interest can be compounded on several different frequencies, including daily, weekly, monthly, and annually. The calculation of compound interest is affected by the frequency of the compounding periods. The higher the number of compounding periods, the greater the compound interest will be.
How Do you Calculate Compound Interest?
Calculating compound interest involves a formula. This formula is as follows: A=P(1 + r/n)nt
In this formula, A is the final amount, and P is the initial principal amount. The r in the equation is the annual interest rate, which will be displayed as a decimal. Then, n is used twice; it stands for the number of times the interest is compounded per year (12 if it's compounded monthly, 1 if compounded annually, and so on). Finally, that will be multiplied by t (or time), the number of years the amount is deposited or borrowed.
Of course, there are online compound calculators, or you can set up an equation in a spreadsheet if you don't want to do the math yourself.
Rule Of 72
The Rule of 72 is another way to calculate compound interest, and with this method, you can do the math quickly and easily. This is not an exact calculation but rather a close estimate of what you will earn on an investment.
With this method, you will be able to approximate the amount of time it will take you to double your investment, but you will need to know the interest rate.
All you need to do is divide the number 72 by the interest rate, aka the expected rate of return on your investment. As an example, if we say your investment has an 8% interest rate, we take 72 and divide it by eight. This tells you that it will take nine years to double your investment at your current rate of eight percent.
Compound Interest and Credit Cards
Compound interest can really help your savings and investments grow, but on the flip side, compound interest can also cost you.
It is common for credit card issuers to use compound interest when you use your card. If this is the case, and you cannot pay the balance of the card off every month, you could find yourself overwhelmed by the interest. Only making the minimum payments might see your balance stay the same or even go up.
As you can see, compound interest can work against you if you're not careful. But remember, if you pay your credit card off in full every month, you won't have to worry about interest charges on your purchases at all.
How Is Compound Interest Different Than Simple Interest?
There are two ways in which interest is calculated. Besides compound interest, there is also a method called simple interest. If you are starting to really dive into your finances or the financial world, you might have also heard about simple interest. Now that you have learned about compound interest, you might wonder how it differs from simple interest.
Simple interest is interest that is only calculated on the principal amount.
When you are saving or investing, compound interest will earn you more over time than simple interest because you aren't just earning based on the principal amount. It can be a small difference at first, but over time, your earnings will grow.
The Bottom Line
Compound interest can be a good thing and help you earn a great deal more money, but if it is working against you, it can be hard to overcome if you only pay a minimum amount.
Knowing and understanding how compound interest works both for and against you will help you maintain a solid financial foundation. We hope you better understand how to grow your investments and let your money work for you.