Compound interest is one of the most important concepts to understand when managing your finances. It can help you earn a higher return on your savings and investments, but it can also work against you when you're paying interest on a loan.
What is compound interest?
Compounding is a process of growing. If you’re familiar with the “snowball effect,” you already know how something can build upon itself. Compound interest is interest earned on money that was previously earned as interest. This cycle leads to increasing interest and account balances at an increasing rate, sometimes known as exponential growth.
How does compound interest work?
To understand compound interest, first, you'll need to understand the difference between simple interest and compound interest. Simple interest is calculated by using only the principal balance of the loan each period. With compound interest, the interest per period is based on the principal balance plus any outstanding interest already accrued.
With compound interest, you’re not just earning interest on your principal balance. Even your interest earns interest. Compound interest is when you add the earned interest back into your principal balance, which then earns you even more interest, compounding your returns.
How can you maximize compound interest?
Compound interest can help you earn a higher return when carefully applied. The starting balance, frequency, interest rate, and time all affect how much of a return you will see. More frequent compounding periods (such as daily) can amass greater returns. The longer your investment time horizon is and the higher the interest rate, the greater the growth potential as well. Evaluate your investments with a financial advisor to see if you have opportunities to increase your earnings. You can also calculate compound interest using our online calculator to see how it can impact your investments over time.
Reinvesting your interest earnings into your investments is a powerful way to maximize your return. The effect of compound interest on your investments can be especially impactful over a longer time horizon. This is part of why it is so important to begin investing at a young age.
In the example below, you can see the benefits of compound interest become more apparent when looked at over a long period of time…
But it's important to know that compound interest can either help you or hurt you, depending on whether you’re saving or borrowing money.
Just as compounding interest can help you grow your savings, it can work against you when paying off debt. Some credit cards compound interest daily on your balance. This equates to a higher interest amount due when you carry over balances month-to-month. Mortgages, on the other hand, do not usually have daily compounding interest. As long as your mortgage payment covers the accrued interest, the interest shouldn’t compound.
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