10 things you need to know about compound interest | My money

When Benjamin Franklin died in 1790, he left $5,000 each to the cities of Boston and Philadelphia. Each city was to create a fund that would last for 200 years. The needy could borrow from the fund at 5% interest. After 100 years, each city could withdraw $500,000 from the fund, leaving the rest to work for the next 100 years. Why did Franklin do it? To help people understand the importance of compound interest.

Gary Foreman

What is compound interest? It’s interest that earns interest. For example, suppose you saved and banked $100 a year ago. He earned $2 in interest last year. This year, you will earn interest on $102 (initial savings plus earned interest). It may not seem like much, but understanding this simple fact can have a major impact on your financial success.

Why is compound interest important to you? Because it can turn a few dollars today into large sums of money over a lifetime. Let’s look at the 10 facts you need to know about compound interest:

1. Anyone can benefit from compound interest. You don’t have to be a Wall Street magician or a Harvard MBA. Almost all investments will earn compound interest if you leave income in the account.

2. Compound interest is a double-edged sword. It’s fine if you regularly save money, but it can be cruel if you borrow money.

3. You want the savings to accumulate as often as possible. It is better for you to compound quarterly rather than annually when saving money. If you are borrowing, the exact opposite applies.

4. Time is on your side. The more money is compounded, the faster it grows. Money growing at 6% per year will double in about 12 years, but it will be worth four times as much in 24 years.

5. Time is not on your side. Credit cards and other open accounts use compound interest against you. This is why “minimum payments” may put you in debt forever.

6. Don’t let today’s low interest rates put you off. It is true that banks do not pay much on savings accounts. But many mutual funds have higher yields on average and have very low minimums and no sales charges. If you can’t apply a few dollars to your savings, most debt (think house or credit cards) will allow you to add any amount to your payment.

7. It adds up faster than you think. If you were to save $5 a month, you would earn 5% compound interest each month and with that continuously for 10 years, you would have put $600 into savings. But the account would be worth $776. And, even if you didn’t add a penny, it would be worth over $1,500 in 15 years.

8. Compound interest can free you from credit cards. Say your interest rate is 14% and you only add $5 a month to your payment. In 10 years, you will avoid $1,315 in payments.

9. You don’t have to be rich for compound interest to work for you. The principal works the same whether you invest $100 million or $100 million. The millionaire may have more investment options, but even the poorest of us can use compound interest to reduce the amount we pay to credit card companies and payday lenders.

10. Compound interest forces you to make sacrifices today to benefit tomorrow. It is true that you will have to do something to save a few dollars today. But, it is certain that the future reward will be greater than the sacrifice.

What’s the bottom line for consumers? Often the difference between financial comfort and poverty is not so great. Saving a few dollars a week may not seem like much, but if you do it regularly, it could make a big difference to your financial future.

Gary Foreman is a former financial planner who founded the website The Dollar Stretcher.com. The site has many personal finance topics, including more information on compound interest for the poor.

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