Compound interest is the eighth wonder of the world. Whoever understands it, wins it. Whoever doesn’t, pays.
This saying, which some attribute to Albert Einstein, perfectly describes compound interest.
What is compound interest? If you have a savings or investment account, it’s money you earn through interest. This is a good thing.
If your loan has compound interest, the interest is charged on your interest. It’s a bad thing.
Let’s take a closer look at compound interest in a savings account. Suppose you have a savings account containing $1,000 and you earn 6% APY, which means annual percentage return. With simple interest, you would only earn $60 on your $1,000 in one year. But thanks to compound interest, you earn more.
Let’s break it down. Each month, your account earns 0.5% interest, or $5. So, at the end of the first month, you have $1,005 in your account. So the next month, when you earn 0.5% interest, you earn it on $1,005, which is $5.025 (we’ll round it up to $5.03) instead of $5. Thanks to compound interest, you have already earned an extra three cents. Your new balance is $1,010.03, which earns you $5.05 in interest. You picked up two extra cents for a new balance of $1,015.08. Over time, those few pennies add up and you earn more and more. That’s why they say to start saving for retirement when you’re young, because over a 40-year period, compound interest really accumulates.
Now let’s look at the dark side of compound interest. Let’s say you have a balance of $5,000 on a loan with compound interest, and it has an APR of 15% – that’s the annual percentage rate – and it’s compounded daily. If you wait 30 days to make your first payment, your balance will already be $5,063.70. This means that even if you made payments of $63.70 each month, the outstanding balance would remain the same for the rest of your life.
As you can see, compound interest can be very expensive. That’s why so many financial gurus advise you to pay off your credit cards first if you’re trying to improve your finances. Car loans and personal loans usually have simple, non-compound interest, so there is a better deal out there. Mortgages have simple interest, but they make you pay everything upfront, so it takes a lot longer to pay off your principal. (The principal is the original amount you borrowed.)
Make sense ? Remember that compound interest in savings is good. But in a loan, it’s bad for your budget.