Compound Interest Explained | fool uk

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Compound interest is a common term in the world of personal finance and investing. This is an important concept to grasp as it can work in your favor or against you. I’ll explain everything you need to know about calculating compound interest, why it’s important, and how it can help you.

What is compound interest?

The most thorough way to explain this term is that it is interest calculated on both a principal sum and accrued interest from previous periods for a loan or deposit.

A simpler way to think about it is that any interest is added on top of the starting amount. So, the next time the interest is calculated, it is on a larger sum.

Sometimes this is called interest earning interest.

This may not seem particularly large, but the compounding effect over time as interest accumulates can be quite amazing. This is why the effects of compound interest are sometimes referred to as “magical”.

Compound Interest Calculation

Although the effects may seem magical, I can assure you that the compound interest calculation uses a simple mathematical formula.

If you like math, you can find the full equation online. If you’re like me and want to simplify things, you can use a compound interest calculator. There are plenty of them on the internet. You just have to enter the required variables and they will then give you a breakdown showing how the interest can accumulate over time.

What types of accounts can benefit from it?

The two main types of accounts that can benefit from the effects of compound interest are investment accounts and savings accounts.

Investment accounts

The power of compound interest works best over a long period of time, and ideally with a high interest rate. For these reasons, you will often hear about compound interest in relation to investing. It should be noted that you must reinvest all earnings for compounding to work.

Savings accounts

Although interest rates on savings accounts may be lower than those on investment accounts, they can still benefit. It is always important to ensure that any interest earned remains in the account.

How to make compound interest work for you

Imagine for a moment that your savings or investment account is a snowball. Each time it turns over and more snow (interest) is added, it grows bigger and attracts even more snow.

Using compound interest to your advantage will accelerate the growth of your savings or investments and help you reach your financial goals faster.

The key factor that allows savings to thrive using this approach is time. The longer you can leave the money in an account growing and the snowball rolling, the greater the cumulative effect will be.

How Compound Interest Can Work Against You

The less exciting part of this concept is that it can really work against you both in terms of investment and debt.

When you invest, compound interest may also apply to any fees or costs associated with your account. Over time, these costs turn out to be much higher than what at first might have seemed like a small percentage.

In effect, you effectively lose all potential gains from these costs, eating away at your investments. This is why it is very important to use one of the best stock trading accounts with low fees or a top-notch facility shares and ISA shares to help you minimize costs.

The lesser-known drawback of compound interest applies to credit cards and loans. When you borrow money there is usually an agreed percentage of interest that you pay back on top of the original loan.

This means that your debts can also have a cumulative effect over time. In order to avoid falling into this spiral of debt, it is really important to try to use a 0% credit card.

If you already have credit card debt, it may be worth upgrading to a credit card balance transfer with a lower interest rate.

To take with

Compound interest can be an extremely useful tool for building wealth, but it can also significantly slow your progress.

To mitigate negative effects:

  • Keep your fees as low as possible when investing
  • Strive for the lowest possible interest rate when you borrow

To build wealth, a higher interest rate and a longer period will reap the most rewards.

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