What is Compound interest? Understanding Compound Interest is key to becoming wealthy and building your independent fortune.
It can help you earn a higher return on your savings and investments, but it can also make things worse when you have interest compounding on the money you've borrowed. In other words, it can work for you or against you. Be sure to get on the right side of Compound Interest.
What Is Compound Interest?
Compounding is the 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.
Start with the concept of simple interest: you deposit money, and the bank pays you interest on your deposit. For example, you might deposit R1000.00 for one year at 5 percent, and you’d earn R50.00 in interest over the year.
What happens next year? That’s where compounding comes in. You’ll start earning interest on your initial deposit, and you’ll earn interest on the interest you earned. In simpler terms:
- You’ll earn 5 percent on your original deposit of R1000.00 again.
- You’ll earn 5 percent on the new R50.00 of interest earnings the bank paid to your account.
That means you’ll earn over R50.00 next year because your account balance is now R1005.00, even though you didn’t make any deposits, so your earnings will accelerate.
At many banks, interest compounds daily and gets added to your account monthly, so the process moves even faster.
If you’re borrowing money, compounding works against you. You pay interest on the money you borrowed, and your loan balance can increase over time, even if you don’t borrow any more money.
Using the Power Compound Interest For Good
One of the ways that compound interest can be most useful is in saving for retirement. Time things right and you can save a lot of money without having to invest anywhere near as much money as you think.
In fact, if you start early enough and choose the right savings and investment accounts you may have to contribute very little at all after the first few years your accounts are active.
So if you think that you are too young to start saving for retirement and you are over, say 21, you are wrong. You could get started tomorrow and even very small contributions will have grown impressively by the time you are ready to retire. We suggest consulting with an independent financial advisor to find the best places to invest your money, and we suggest doing so as soon as you can.
What is Compound Interest and How to Avoid the Dark Side
As we mentioned, compound interest has a dark side. It's not just formal loans that accrue compound interest, it's more commonly used in credit cards loans too. That dinner that you put on your credit card last month? The one that was a bit of a splurge, but you did it because you just got that credit line increase? If you don't pay it off right away it could end up costing you a lot more than you bargained for.
In the end, as we said at the beginning, compound interest is a 'trick' that can work for or against you. Make a conscious effort to stay on its good side, and you'll find that maybe it is magic after all.