can be one of the most beneficial or damaging things for your wallet. And it all depends on whether you earn it or pay for it.
When you earn compound interest, you could end up with a much larger balance than you originally invested. But when you’re charged compound interest, you could end up paying a lot more than you borrowed.
But what is compound interest anyway? How it works and how it differs from
? We’ll take a look.
What is compound interest?
Compound interest is the process of adding interest to a principal amount and basing future interest on that new balance. Here’s how it works.
Imagine you invest $100,000 in the stock market and in the first year you get a 10% return. This would represent a growth of $10,000, increasing the overall value of your portfolio to $110,000.
Then, in the second year, you earn another 10%. But, remember, now you earn 10% of $110,000 instead of $100,000. So you would actually win $11,000 interest in the second year, bringing the value of your account to $121,000.
That may not seem like a big difference. But compound interest continues to gain traction over time. Each year you will earn a little more interest on a slightly higher balance. In fact, at a 10% annual return, compound interest would help your account grow to over $1 million in just 25 years.
And that’s without making any additional contributions for the entire 25-year term.
How Compound Interest Compares to Simple Interest
Now, let’s take the same example above and imagine that you were paid with simple interest instead.
If you earned 10% simple interest, you would earn $10,000 each year over 25 years — you would only earn interest on your principal investment.
So, over 25 years, you will earn $225,000 in simple interest. After adding this to your starting balance of $100,000, you will find that your ending balance is $350,000.
That’s over $650,000 less than you would have had your interest increased throughout the course.
Fortunately, most investments use compound interest. On the other hand, simple interest is most often used for installment loans, such as mortgages and car loans.
This is generally good news. But there are situations where you might have to pay compound interest on the debt, which we’ll discuss later.
How often is interest compounded?
The amount you earn (or pay) with compound interest is greatly influenced by compounding frequency.
When comparing CDs or high-yield savings accounts, for example, you may see a variety of compound schedules, such as daily, monthly, or semi-annual.
The more frequent the schedule, the more compound interest you will earn over time. So an investment product with a slightly lower interest rate could still be more valuable to you over time if the compounding schedule is more frequent.
To help you determine the true value of compound interest over time, you’ll need a way to calculate it. We will see how to proceed next.
How to Calculate Compound Interest
Not a fan of math? Its good.
You don’t have to calculate compound interest with pen and paper. There are many tools available that can help you calculate compound interest in seconds.
For example, Investor.gov offers a simple and easy-to-use compound interest calculator. Simply enter your principal balance, estimated interest rate, and term, and the compound interest calculator can show you immediate results.
Do you plan to continue making regular contributions over time? The compound interest calculator can also take this into account.
The compound interest formula
If you’re ambitious and want to do the math yourself, here’s the compound interest formula:
FV = PV x (1 +i)n
In this formula, VF means future value, PV means present value, I denotes the interest rate, and not means the number of compounding periods.
Suppose you want to calculate your compound interest income on a $10,000 investment earning 5% compound interest annually for five years. Here is how it would be expressed in the formula above.
- FV = $10,000 x (1 +0.05)5
- FV = $10,000 x 1.055
- FV = $10,000 x 1.2762
- FV = $12,762.00
Another quick way to calculate your compound interest return is to use the rule of 72. This rule shows you how quickly you can expect your investment to double over time.
It’s easy to use the rule of 72. Simply divide the number 72 by your expected interest rate. So if 6% was your expected rate of return, you could reasonably expect your investment to double every 12 years (72 divided by 6 = 12).
How to Avoid Paying Compound Interest
Earning compound interest is great. But paying compound interest is anything but. In fact, it can have disastrous effects on your finances.
As mentioned earlier, most large loans, such as car loans and mortgages, use simple interest formulas. However, there is one type of debt that uses compound interest: credit cards.
Most credit card issuers compound interest daily. This interest will begin to accrue the day you make a purchase with your credit card.
However, the good news is that most credit card issuers will give you a grace period until the due date. In other words, if you pay your statement balance in full before the due date, they will waive the interest charges. But interest will be assessed on any part of the balance that remains unpaid.
So if you don’t want to pay compound interest, avoid carrying a credit card balance past the due date as much as possible.
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