Your money won’t grow without interest.
Keeping cash in a shoebox at home on a rainy day will only add to your grand total as you add more.
On the other hand, if you borrow $ 50 from your sister, the amount you owe will not increase to $ 75 when it is time to repay it because it is an interest-free loan. (Thank you sister.)
But if you kept your savings in a bank account or took out a loan from a payday lender, the outcome would be different. You see an increase in your savings – or what you owe – because of compound interest.
But what is it and how does compound interest work?
What is compound interest?
Compound interest is a basic financial concept that explains how your money can grow exponentially. Your bankroll will increase as you earn interest on the interest.
A little confusing, we know. Let’s break it down using an example.
If you had $ 1,000 in an account that earns 5% interest annually, you will receive $ 1,050 at the end of the year. If your interest increases, you’ll earn 5% of your credit of $ 1,050 – an additional $ 52.50 – by the end of the second year, for a total of $ 1,102.50.
Simple interest, on the other hand, is only interest in your original credit. Your interest income will not be taken into account when calculating the interest in the following years.
If your $ 1,000 was in an account that earned simple interest at the same 5% annual rate, you would still have $ 1,050 at the end of the first year. However, at the end of the second year, you would only earn interest based on the $ 1,000 originally deposited, not the $ 1,050. You’ll earn an additional $ 50 instead of $ 52.50, leaving you with a balance of $ 1,100.
Now, an extra $ 2.50 isn’t a big deal, but let’s say you left that money in your account for 20 years instead of two. With compound interest, you would have $ 2,653.30 at the end of 20 years. With simple interest, you would only have $ 2,000.
Calculation of compound interest
While there’s a fancy formula you can use to determine how your money will grow with compound interest, we’re going to tell you a secret. You can find a number of compound interest calculators online – including this by the US Securities and Exchange Commission.
Just plug in your initial investment, how long you want to save, your interest rate, and how often the interest is compounded, and voila!
If you’re curious or interested in algebraic equations, the compound interest formula is:
A = P (1+[r/n]) rt
A = the total amount you will end up with
P = the principal amount (which you start with)
r = annual interest rate (as a decimal number)
n = number of interest connections in one year
t = time in years
The math is a lot easier if all you want to do is figure out how many years it would take your money to double. Using the so-called rule of 72, divide 72 by the annual interest rate (not written as a decimal number).
If your $ 1,000 savings are earning 6% interest annually, it will take 12 years for your money to grow to $ 2,000.
Additionally, you can use Rule 72 to find out what rate of interest you need to earn in order to double your money in a given number of years. You calculate this by dividing 72 by the number of years.
For example, in order for your money to double in 8 years, you need an annual interest rate of 9%.
How you can get the most out of compound interest
When you understand the factors that affect the growth of your money, you can harness the power of compound interest.
Grab a great price
It’s pretty obvious that the higher the interest rate, the higher your returns. But how do you get the best interest rate out there?
If you’re depositing money into a savings account, look for a High yield savings account – one that exceeds that national average of 0.04% interest. Online banks often offer better interest rates because they don’t have the overhead costs that stationary banks create. However, this does not mean that traditional banks do not offer competitive interest rates.
Interest rates from Money market accounts can rival some high yield savings accounts, so this is another option.
When you open one Payment slip (or CD)the interest rate is usually higher if you choose a longer term. But make sure you are okay with leaving your money untouched for that long. You will be charged for withdrawing funds from a CD before the due date.
When you invest in the stock market, your profits are technically returns, not interest, but the concept is similar. Personal financial experts say that you can expect average returns between 6% and 10% on a long-term investment. However, the stock market is volatile and carries a higher level of risk.
The early bird gets the larger worm
The longer you let your savings sit, the greater the compounding may be in your best interest (pun intended).
If you put $ 1,000 into an account that earns 5% interest annually by the age of 25, that money would grow to $ 7,039.99 by the age of 65. If you were to save the same amount at the same rate by the age of 35, you would have $ 4,321.94 by the time you turned 65. If you waited until you were 45, you would have only $ 2,653.30 by age 65.
Save sooner rather than later to really benefit from compound interest.
Don’t stop saving
It can be tempting to put money in an interest-bearing account and just let the magic of compound interest do its thing. But you will benefit more from it – a amount more – if you regularly contribute to your savings.
Remember the $ 1,000 from the previous example that increased to $ 2,653.30 at the end of 20 years?
Let’s say you only had half of that at the start, but you’ve committed to depositing $ 10 into your account every month. That money, which earns interest on your original capital of $ 500 plus the $ 10 you’ve invested month after month for 20 years, would grow to $ 5,294.56.
With monthly deposits of $ 10, you’ve invested $ 2,900 of your own money – and earned $ 2,394.56 in interest – over 20 years. If you save $ 1,000 initially and make no additional contributions, you will earn only $ 1,653.30 in interest.
So keep putting money away, even a little at a time.
Look at the frequency
How often interest income is calculated also plays a big role in how much you can save.
Our earlier examples were based on interest compounded once a year. However, interest rates can be increased on other regular frequencies such as monthly or daily.
The compounding frequency can also be discussed in terms of compounding periods. If the interest is calculated monthly, you have 12 interest periods per year. If it is put together daily, you have 365 compounding periods per year.
Using the same example of $ 1,000 in an account with 5% interest, after 20 years at different compound interest frequencies, this is what you get.
- Annually: $ 2,653.30
- Monthly: $ 2,712.64
- Daily: $ 2,718.10
The more times the interest rate increases, the greater your savings will be.
And just because your bank pays your interest income into your account only once a month doesn’t mean that the interest is calculated monthly. Many financial institutions that pay compound interest on a daily basis wait until the end of their monthly billing cycle to make these profits.
Another important note: if you come across interest rates advertised by a financial institution or lender, the APY (or Annual Percentage Yield) takes the compounding frequency into effect, while the APR (Annual Percentage) does not.
How can compound interest be a disadvantage?
While compound interest can save a huge amount of money, it’s not just rainbows and roses. Compound interest is also the reason you never seem to get past your credit card debt on minimum payments.
Just as your savings grow when interest rates rise, so does your debt.
When you buy a credit card or take out a personal loan, your lender charges you interest which is added to your balance. You will then be charged interest based on your new balance – the original amount plus any accrued interest (minus any payments you have made).
Compound interest can really hurt you with negative depreciation. In this case, your monthly payment will be less than the accrued interest over that period and your outstanding balance will increase rather than decrease.
When you take out a loan or open a new credit card, here are some things to keep in mind:
Get the lowest interest rate you can. Increase Your Credit Score This usually leads to lenders offering you lower interest rates.
Keep your loan period short. You pay less interest with a three-year car loan than with a five-year loan.
Pay more than the minimum. As you scour your credit card statements, you’ll see a section that tells you how long it would take your balance to pay off if you only made minimum payments and how much interest you would pay versus the payments required around your To withdraw funds in three years and how much you would save.
Pay every two weeks. You’ll end up putting more money in your capital and paying less interest by paying off your debt every two weeks instead of once a month.
Not all lenders increase the interest they charge. Interest charged on a federal mortgage loan, auto loan, or federal student loan is usually simple interest – interest based solely on your original principal loan amount.
Nicole Dow is a senior writer at The Penny Hoarder.
This article originally appeared on www.thepennyhoarder.com