Compound interest: how does it work to create wealth?

When you deposit funds into a savings account or certificate of deposit, you can earn interest allowing your money to grow in the account over time. On the other hand, when you have a credit card or other type of loan, you can see how it can negatively affect you if you end up running out of balance or not making a payment on time.

It’s important to understand how compound interest works and how it impacts your overall wealth, for better or worse.

What is compound interest?

Compound interest is interest earned on both the initial deposit you make into an account and the interest the account has already accrued, also known as “interest on interest”. The frequency of compound interest depends on the frequency cycle, which can be daily, monthly or yearly.

Generally, the larger the account, the more interest is earned. For example, if you have a principal balance of $3,000 in a savings account that earns 2% compound interest annually, your account will grow to $6,625 after 40 years. But if your account is compounding monthly interest, all other things being equal, you will have $6,673.

Not only can compound interest grow your savings at a faster rate than simple interest, but it also requires a lower initial principal balance to achieve the same target balances. But it’s important to note that it may take some time before you see a significant difference in your account balance, even with a faster compounding schedule, so start saving as soon as possible once you have a financial goal. on your mind.

Previously, we saw an example of a savings account that compounds interest. But there are other types of accounts that benefit from interest on interest.

Savings accounts: Savings accounts are a type of bank account that earns interest on funds held. Funds held in a savings account at a bank or other financial institution may earn interest on a daily, monthly or annual schedule. Funds are easily accessible through account transfers, withdrawals, and sometimes checks.

Certificates of Deposit (CDs): A CD is a type of savings account that earns interest over a set period of time. Generally, a CD offers a higher rate of return than a traditional savings or checking account, but there is a condition that the funds are not touched during this period, known as a term. These terms range from three months to several years and the investment compounds interest daily or monthly as long as it is held in the CD. If you choose to withdraw your funds before the end of the term, you may be charged an early withdrawal fee and you will lose potential interest.

Student loans: Compound interest does not always benefit the consumer; it works against you when you take out loans or credit cards. This includes student loans. While all federal student loans pay simple interest, some private loan issuers charge compound interest annually, monthly, or even daily. This is often referred to as interest capitalization, which is when the total accrued interest is added to the loan balance and begins to earn interest. This can happen after a grace period ends, such as when a student graduates, and can be detrimental to borrowers who make on-time payments almost entirely for interest and struggle to repay their principal balance. .

Credit card: Like student loans, credit cards accrue interest on the balance owing daily, monthly, or annually, making it difficult to get ahead on payments. If you don’t pay off your credit card and are charged interest on your purchases, you can quickly be trapped into paying exorbitant prices for everyday purchases like groceries, says Kenneth J. Dean, Certified Financial Planner and Chief Financial Officer. planning at Winthrop Wealth, a wealth management advisory firm dedicated to maximizing the impact of its clients’ wealth.

How does compound interest work?

Although compound interest may seem complicated, it is actually made up of the same components as simple interest with a few additional elements.

Main balance to start: The initial value of funds in an account. For example, a $20,000 student loan would have a principal balance of $20,000. On the other hand, a savings account can also have a main balance, such as an initial deposit of $100.

Interest: A small percentage of the sum of the principal balance and interest previously earned. Expressed as a percentage, interest is the amount charged to the account holder to borrow money or earned by the account holder as income. When investing, you want a higher interest rate because a higher rate will take less time for the investment to double, Dean says. But if you take out a loan or use a credit card, you want a lower interest rate to lengthen the time it takes for your debt to double in amount.

Deposits and withdrawals: Funds entering or leaving an account can have an impact on the amount of interest generated by the account. If you deposit funds to pay off a student loan, for example, you decrease the principal balance and the amount of accrued interest, which in turn reduces the compound interest on the loan. But if you have a savings account, you deposit funds to increase the interest-earning balance, thereby increasing the overall interest accrued in the account.

Dialing frequency: How often compound interest in your account can affect your interest earned: The more frequently compound interest occurs, the more interest you earn. Normally, accounts accumulate on a daily, monthly or annual schedule, but they can also accumulate on a quarterly or semi-annual basis. If you have a credit card with interest compounded daily, it will take you longer to pay off the balance than if it were compounded annually or even monthly, all things being equal, Dean says.

Duration: In addition to how often an account earns interest, another timing factor is how long your savings need to grow. If you have a savings account compounded on an annual basis, but withdraw the funds before the end of the year, your money will not have had a chance to accumulate. Instead, “you want an investment to accumulate more frequently because the value will increase in the end,” Dean explains.

How it’s calculated

If you’re curious about how quickly your investment will need to grow, you might want to calculate how much compound interest your funds are earning. Knowing how compound interest is calculated can also help you understand the factors you can manipulate to achieve your financial goals.

For example, let’s say you need to save $15,000 within five years to pay for your wedding. Since you can’t adjust how long you have to compound interest, you may need to find a savings account with a higher interest rate, such as a high-yield savings account.

Sometimes you can adjust the term for additional compounding periods, but you don’t have the power to change the amount of interest your account earns. Whatever financial goal awaits you, learning how to harness the power of the compound interest formula will help you design a savings plan. Here is the formula:

A = P (1 + [r / n])(NT)

A: Future value of investment or loan, including accrued interest
P: Principal balance of investment or loan
R: Annual interest rate, expressed in decimal points.
NOT: Number of times interest is compounded per year
J: Duration in years during which the balance is invested or borrowed

Let’s say you deposit $1,000 on a 10-year CD that pays 5% interest, compounded monthly.

In this example, we are solving for the amount the account will accumulate over time, which is A. We know that P = $1,000; t=10; r=0.05; and n = 12. So let’s insert these numbers into our formula.

A = $1,000 (1 + [0.05 / 12])(12*10)
A = $1,000 (1 + [0.05 / 12])(120)
A = $1,000 (1 + [0.00417])(120)
A = $1,000 (1.00417)(120)
A = $1,000 (1.6477)
A = $1,647.67

After 10 years, the original $1,000 deposit will have earned $647.67 in interest, totaling $1,647.67 in savings.

Simple Interest vs Compound Interest

If you have a car loan, chances are you will be charged simple interest. This is good because simple interest is calculated based on the principal balance. This means your lender can’t charge you interest on the interest your loan has accrued over the life of the loan, saving you money.

But if you’re saving for a long-term goal like retirement, you want to look for an account that accrues compound interest and earns interest on the total account balance, including interest earned. This will give you a higher return and benefit you in the long run.

The take-out sale

Understanding how compound interest works can help you make informed decisions about your investments and loans. If your goal is to pay off debt, compound interest can really burn you if you give it time to grow in silence, and it can quickly erode any kind of wealth you’re trying to build in your lifetime.

On the other hand, if your investment is compounded with interest, the power of compound investing works on your side. You can take advantage of this by starting to save as early as possible, giving your account more time to grow your wealth.

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