Whether you’re heavily involved in your personal finances or take a more hands-off approach, you’ve likely heard about the term “interest.” If you’ve ever used a credit card, you see it on your monthly statement. If you have a savings account, you see it there as well.
Interest is everywhere in the financial world. More specifically, compound interest is what most financial products use. In this article, we discuss what exactly compound interest is and how it can work for you — or against you.
What Is Compound Interest?
Interest can be calculated in one of two ways: simple interest or compound interest. To calculate simple interest, just multiply the rate by the principal. Since simple interest is so straightforward, it’s easy to determine exactly how much interest will ultimately be charged.
For example, let’s say you have an auto loan of $20,000 with an annual 6% simple interest rate. You’ll pay $1,200 per year in interest.
Resource: Refinancing Your Auto Loan to Save Money
Compound interest, on the other hand, is more variable. Compound interest is calculated on both the initial principal as well as the accumulated interest. In this way, the amount of interest you pay per year, or even per payment cycle, can vary. Each payment cycle, the accumulated interest is combined with the principal to calculate the next payment cycle’s interest.
Let’s look at the same loan amount mentioned above ($20,000), but with compound interest. Instead of a simple 6% rate, you’ll be paying interest on your interest… resulting in an average of $1,395.06 per year in interest. Over the life of the loan, you’ll be paying $1,170.38 more with compound interest versus simple.
While simple interest is the easier to calculate out of the two methods, it’s rarely used by financial institutions. Credit card issuers, banks, and other financial institutions tend to use compound interest for their financial products — and by looking at how much more you owe with compound, it’s easy to understand why.
How Compound Interest Works in Your Favor
One notable way that compound interest works in your favor is in investing. In particular, if you have a large initial balance and a lot of time to let it grow, compound interest can work wonders for your money. Your money will grow exponentially as you earn interest on not only on your initial balance but also on the accumulated interest. Just as you pay interest on your interest when talking about a compounding loan, you will also earn interest on your interest when talking about a compounded investment.
A good way to explain how compound interest works in your favor is to take a look at how the Rule of 72 works. The Rule of 72 is used to determine how long it’ll take to double your money, given a fixed return rate. You simply divide the number 72 by the annual rate of return. The result is how many years it’ll take to double your money.
Let’s see the Rule of 72 in action:
- You have $10,000 to invest in an index fund
- You’re assuming an average annual return rate of 7.25% based on historical data
- 72 / 7.25 = 9.9 years to double your money
|Year||Balance at beginning of year||Return rate||Balance at year end|
As demonstrated in the table, your initial investment of $10,000 has increased by another $10,000 in just 10 years with the power of compound interest! Of course, stock market fluctuations are unpredictable, and you won’t get exactly 7.25% in annual returns every year. But this gives you an idea of how quickly your money can grow with compound interest.
How Compound Interest Works Against You
Compound interest works against you primarily in situations when you borrow money. Take most loans, for example. The interest that builds on the initial principal can be surprising! The reason you end up paying much more than you initially borrowed is because of compound interest. When you have a loan (or some other form of debt), you continue paying interest until the loan, plus all the interest, is paid.
As you make payments, more interest is compounded onto the remaining balance. Your remaining balance is now composed of both the loan amount and the previous interest added. As mentioned, new interest is then calculated on top of the old interest! If you are making only the minimum payments, you’ll find that you’ll end up paying a lot more than you originally borrowed.
To avoid letting the negative effects of compound interest put you further into debt, it’s wise to pay off as much as possible each month. For credit card bills, try to get into the habit of paying them off in full each month to avoid interest completely. As for larger debts like student loans or a mortgage, paying even just a little more than the minimum payment each month can result in substantial savings down the road.
Compound interest is a powerful concept. Knowing how it works can help you build wealth and manage your debt better. Once you understand how compound interest can work both for and against you, you can take your finances into your own hands and make more informed decisions. The key here is to minimize the amount of interest you pay on your debts and maximize the amount of interest you earn on your investments.
How has compound interest affected your finances in a surprising way?