How does compound interest work?

3 min read

compound interest

If you are a person who is looking forward to managing your own finances, it is important to have a solid understanding of compound interest. This knowledge will be able to provide you with the opportunity to refrain from many frustrating situations that you may come across in the future. On the other hand, it will provide you with the chance to receive a higher gain out of your investments and savings as well.

What exactly is compound interest?

Compound gives out the meaning of growth. This is pretty much similar to the snowball effect, which you are familiar with. It has the ability to keep on growing and get bigger along with time.

By definition, compound interest is the interest that is earned on money, which was previously earned in the form of interest. This is a cycle, which can lead you towards increasing the interest amount over and over again. Along with that, you will also be able to keep on increasing the account balances along with time. Hence, you can even think about calling it as exponential growth.

In order to get a better understanding of compound interest, you should have a solid picture of what simple interest is all about. When it comes to simple interest, you are depositing money. In return, the bank will pay interest for the deposit. For example, if you go ahead and deposit $100 at a bank for an interest rate of 10%, you will be able to receive an interest of $10 at the end of the year.

On the next year, your initial deposit amount, which is $100 will be considered for the calculation of interest. 

But when it comes to compound interest, your initial deposit will be considered as $110. That’s because the initial deposit amount and the interest that you gained for it are now combined and they are used to calculate the compound interest. Hence, you will be able to receive a higher rate of interest in the next year. Likewise, you will be able to keep on earning money. In the meantime, you will also notice how your investment is getting bigger along with time. Hence, you can earn more and more money along with time.

The same works for money that you have borrowed as well. In case if you have borrowed money at a compound interest rate, you should be extra mindful about the fact. That’s because there is a possibility for the interest amount to grow along with time. Hence, you need to take control of the situation and make sure that you don’t end up with a situation, where you have to pay a massive rate of interest. This can provide you with the opportunity to keep the peace of mind in the long run.

How to get the most out of compound interest?

Now you are aware of what compound interest is all about. While keeping that understanding in mind, you should also learn how to get the most out of compound interest and make sure that you don’t run into any investment pitfalls. Here are some useful and effective tips, which can provide you with the chance to earn the most out of compound interest.

1. Start saving money early

If you have any plans to grow the savings, you are encouraged to think about start saving money early as much as possible. In addition to that, you will need to think about saving money often. When it comes to compound interest, time will be your best friend.

saving money
Photo by Michael Longmire on Unsplash

It will take a considerable amount of time for compound interests to gain momentum. When you are building up momentum, you will be able to gain strength along with time as well. When you start early, you don’t need to save a lot of money as a person who waits to start saving money. In here, you will be getting an excellent heart start, which can deliver amazing results in the long run. You need to learn how to be patient when venturing into investments. In fact, you must leave all the money alone. If you can focus on long term returns, you will be able to do it with ease.

2. Take a look at the Annual Percentage Yield

People who are looking to take advantage over compound interest should make it a habit to take a look at the annual percentage yield on a regular basis as well. You need to take a look at the annual percentage yield in all the investments, including CDs and savings accounts. Then you will be able to get a better understanding of the true annual rate that you are receiving. 

You don’t have to go through a lot of hassle to get to know about the annual percentage yield. That’s because banks are making all the details available on the public. Along with that, you must discuss with the bank and try your very best to get a decent interest rate for the savings. You should not think about changing the bank because you are gaining an interest rate of around 0.10%. However, this can be an exception when you have a massive bank balance.

3. Settle your debts quickly

As mentioned earlier, compound interest has got the ability to work against you as well. You should be mindful about it and make sure that you don’t run into any issues with compound interest. That’s why it is important to settle your outstanding debts quickly as much as possible. For example, you need to settle the minimum amount that your credit card is asking to pay. In case if you have a student loan, you need to refrain capitalizing the interest charges. You should also make sure that you are making the interest payments. Otherwise, you will end up with a surprise soon after graduation. 

Keep these tips in your mind and go ahead when dealing with compound interest to get the best out of it.

Simple vs Compound interest

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