If you have credit card debt, personal loans, retirement accounts, or other investments, compound interest is likely to affect your money, for better or for worse. Compound interest can affect your savings or debt by thousands dollars, but many people don’t understand how it works.
When you understand why making minimum payments on your credit cards or loans is a bad idea, and why choosing investment accounts with higher compound interest rates is a good idea, you may find a little more easy to change your spending habits. A major factor in personal financial success is to understand compound interest, to maximize its benefits and to eliminate or reduce compound bad interest. Let’s see how it works.
What is compound interest?
With compound interest, you earn interest on your main account balance and any interest already earned. In comparison, simple interest only bears interest on the principal balance.
Let’s take a look at an account with a $ 100,000 balance earning 10% a year and see what compound interest can do. Year zero includes only the principal balance. This graph assumes that you never add any additional money to that initial $ 100,000. It also assumes a constant interest rate all the time. You can check your numbers on this compound interest rate calculator.
|Simple interest||Compound interest|
|Year 0||$ 100,000||$ 100,000|
|Year 1||$ 110,000||$ 110,000|
|5th year année||$ 150,000||$ 161,051|
|Year 10||$ 200,000||$ 259,374|
|Year 20||$ 300,000||$ 672,749|
In the “Simple Interest” column, you can see that each year you earn 10% interest only on this initial capital balance of $ 100,000. In the “Compound Interest” column, you earn 10% interest on the total account balance each year, including any interest you have earned in previous years.
As you can see, compound interest makes a major difference, especially when applied over a long period of time. The reason is that compound interest generates interest on more money than simple interest.
Most accounts are compounded daily or annually, although some savings accounts are compounded quarterly.
How compound interest can hurt you
If you have a credit card, car loan, student loan or personal loan, your interest rates are likely to rise daily. The daily amount may seem tiny, but it adds up quickly.
Suppose you have a credit card with a balance of $ 5,000 and an interest rate of 19%. Your daily interest rate (19% divided by 365) is .00052. Multiply this number by your average daily balance (in this example, $ 5,000), and you will see that you accumulate $ 2.60 of debt every day, even if you are spending no more money.
Multiply this by the number of days in the billing cycle (30). Your total accumulated monthly interest is $ 78. If you make minimum payments and do not make any additional purchases, paying for your credit card will still take a long time. In this case, if you have made a Payment of $ 100 a month, it would take eight years to pay off this debt, and you would pay a total of $ 9,985, almost double what you spent on the card!
In the case of a debt, compound interest can significantly increase the amount you pay to a lender.
according to Nerd wallet, the average household has about $ 135,768 in debt (including a mortgage). The study also found that the average American had $ 6,929 in credit cards, $ 47,671 in student loans and $ 28,033 in car loans. When you factor in compound interest, each of these can cost you a ton of money over time.
How Compound Interest Can Help You
Compound interest can also be an advantage. As we have shown in the graph above, simply investing in an account with compound interest versus simple interest can prove to be successful over several years. If, like most people, you don’t have $ 100,000 to pay into a compound interest account, but you can still take advantage of compound interest by contributing regularly.
Suppose you start with an initial investment of $ 1000 and you contribute $ 250 per month for the next 30 years with a 10% return (we will keep the interest rate stable, to simplify the calculations), compounded annually. After 30 years, your savings will have reached approximately $ 510,931.47. Like all good things, time is a major part of a successful financial recipe, especially when it comes to earning money on interest.
Compound interest takes a bit of math, but the concept is simple. When you learn to maximize the benefits of compound interest by making smart investments and reducing the negative effects of paying down debt faster, you will have more control over your financial future.