Without interest, your money doesnt grow.
(Thanks, sis.)
Youd see an increase to your savings or what you owe due to compound interest.
But what is compound interest, and how does it work?
What Is Compound Interest?
Compound interest is a basic financial concept that explains how your money can grow exponentially.
Your balance increases by earning interest on the interest.
Probably not as good as youd like.
It always seems like an uphill battle to build (and keep) a decent amount in savings.
But what if your car breaks down, or you have a sudden medical bill?
Ask one of these companies to help…
A bit confusing, we know.
So lets break it down with an example.
Simple interest, on the other hand, is interest on only the original balance.
Your interest earnings arent factored in when calculating interest in subsequent years.
Youd earn another $50 instead of $52.50, leaving you with a balance of $1,100.
Did you know?
With compounding interest, youd have $2,653.30 at the end of 20 years.
With simple interest, youd have only $2,000.
How to Calculate Compound Interest
Calculating compound interest doesnt require major math skills.
While there is a fancy formula to calculate compound interest, well let you in on a secret.
The compound interest is calculated for you.
Youd calculate that by dividing 72 by the number of years.
But how do you score the best interest rate out there?
Online banks often provide better rates because they dont have the overhead costs that brick-and-mortar banks do.
That doesnt mean traditional banks arent offering competitive rates though.
Interest rates frommoney market accountscan rival some high-yield savings accounts, so thats another option.
But see to it you are okay with leaving your money untouched for that long.
You are charged fees for pulling money out of a CD before its maturity date.
However, the stock market is volatile and involves more risk.
If you waited until you were 45, youd only have $2,653.30 by age 65.
Make compound interest work best in your favor by allowing more time for accumulated interest to grow.
But youll benefit more alotmore if you regularly add to your savings.
Remember the $1,000 from the previous example that grew to $2,653.30 at the end of 20 years?
When you initially save $1,000 and make no additional contributions, you earn only $1,653.30 in interest.
So keep putting away money, even a little at a time.
More frequent compounding leads to greater savings growth.
Our earlier examples were based on interest that was compounded once a year.
However, interest can be compounded at other regular frequencies, such as monthly or daily.
Compounding frequency can also be discussed in terms of compounding periods.
If interest is compounded monthly, youd have 12 compounding periods in a year.
If its compounded daily, youd have 365 compounding periods in a year.
The more often interest is compounded, the greater your savings will grow.
How Does Compound Interest Work to Your Disadvantage?
While compound interest can be a significant savings boost, its not all rainbows and roses.
Just as your savings balance grows when interest is compounded, so does the balance of what you owe.
Compound interest can really hurt you in the case of negative amortization.
Youll pay less interest with a three-year car loan than you will with a five-year loan.
Not all lenders compound the interest they charge.
Nicole Dow is a senior writer at The Penny Hoarder.
(Can you sense my millennial sarcasm there?)
You know which ones were talking about: rent, utilities, cell phone bill, insurance, groceries…
