Power of Compound Interest
Is the power of compound interest magic? The answer is no.
Compound interest is a vital yet often misunderstood financial concept that every adult needs to master. Compound interest is a potentially powerful tool that can help you strengthen your overall financial health. The following guide will help you understand more about compound interest, including its overall power.
What Is Compound Interest?
First: what is compound interest, exactly? In the most basic of terms, compound interest refers to interest which is earned on reinvested interest. Compound interest can either be paid to you via investments; or be paid by you in regards to debts.
To break this down, consider the following scenario: let’s imagine that you have invested $1,000 with a 5% interest rate; this amounts to an earning of $50 per year. Then, you take that $50 worth of earned interest and reinvest it; meaning you have now invested $1,050 for an interest earning of $52.50 per year. That additional $2.50 is your compound interest.
Naturally, in real life scenarios, compound interest usually involves a more significant amount of money than $2.50. Real life compound interest is often more complex. Complex since money can be compounded multiple times during an investment period. The results lead to larger investment growth.
Why Compound Interest is Significant
Compound interest is significant because it can notably alter the amount of interest that your investments earn. Furthermore particularly if they have a larger investment period and they will be compounded multiple times.
Another reason why compound interest is significant is related to debts. Compound interest accrues not only on investments, but it can grow for loans, mortgages and credit card debt as well. This means that you’re final interest payment will not only be on the interest for the initial debt, but on compounded interest on top of that initial interest.
How Do You Harness the Power of Compound Interest?
The quick answer is to start saving or investing in anything that offers interest. Now that you understand the basics of compound interest, you are a step closer towards harnessing its power.
Before you take action on any investments or accept a financial loan using a traditional loan, credit card or mortgage, you need to consider what the compound interest will be in the end. The higher the compound interest, the higher your payment–or the higher the amount of money you will have to pay. In turn, this will help you make more beneficial financial choices, as you can plan to pay for the higher compound interest on debts or choose investments which have a higher compound interest.
One factor to look for when you want to harness the power of compound interest is how often the interest is going to compound. Some interests compound once per year, others twice per year, and others per quarter. If the compound interest is compounding on your investment, meaning you will see financial gain through compound interest, then you should look for interest which compounds as often as possible.
By contrast, if the compound interest is going to be something you’ll have to pay for in the end, look for compound interest that compound less often–ideally, once per year. Regardless of whether you’re receiving or paying for compound interest, remember this key rule: the more it compounds, the higher it will be. Start with good habits like the ones discussed on our article about successful financial habits.
