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Compound Interest: What Is It And How Does It Work?

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The best kind of money is the money you make while you’re asleep. Magical, effortless returns like these typically come from a passive investment. There are various types of passive investments, like real estate, product royalties, or affiliate marketing. But by far, taking advantage of compound interest is the simplest passive investment one can imagine.

In this article, you’ll learn:

  • What compound interest is, and how it differs from simple interest
  • Why compound interest is so powerful
  • How to take advantage and make compound interest work for you
  • Situations where compound interest may work against you

What is the Difference Between Compound and Simple Interest?

Two basic types of interest can accrue on any financial account, simple and compound. The key difference between the two is that simple interest is calculated based on the principal amount, while compound interest considers the interest that money accrues when calculating future interest. To put it simply, compounding is the effect of interest on top of interest.

Simple interest is often used with car loans where you pay a declining amount of interest over the life of the loan, and you know exactly what your payments will be through the final due date. In contrast, compound interest is used with money invested in a savings or taxable brokerage account or on interest due on a credit card or personal loan.

The formulas outlined below for calculating simple and compound interest look a little different. 

Simple interest equation → A = P(1+rt)

The final amount, A, is equal to the principal, P, multiplied by one plus the interest rate, r, times the number of years the investment is active, t.

Compound interest equation → A = P(1+ r/n)nt

The final amount, A, is equal to the principal, P, multiplied by one plus the interest rate r, divided by the number of times interest is applied, n, which is often 1 (annual), 12 (monthly), or 365 (daily).

Since the interest is compounding, the value in parentheses is then raised to the resulting power of the number of times interest is applied, n, multiplied by the number of time periods elapsed, t.

Now, if you’re not a math wiz, and the old-fashioned pen and paper approach seems a bit too confusing, it’s 2020, so you can use a handy online calculator that takes only seconds to calculate compound or simple interest. Once you perform some calculations, it becomes clear that the compounding effect is incredibly powerful.

Why is Compound Interest So Powerful?

The beauty of compound interest on savings is that it happens in the background, and there’s nothing you need to do besides making sure your funds are invested. The money you’ve stashed away under the mattress isn’t doing you any favors when it comes to returns.

Let’s take a simple example and say you’re 25 years old and have $10,000 you’ve saved up to put into an investment. You don’t plan on needing to use that money until you’re 65 years old, which means it has 40 years to grow.

If you plan for a 5% average return on your investment compounded monthly, that means in 40 years, with no additional contributions, you’d have just over $70,000. Not bad, right?

But then consider if you committed to just a $25 monthly contribution on top of that $10,000. That’s a measly $300 per year and $12,000 investment over 40 years. But it would shift the trajectory of your returns from around $70K to over $110K. Now that’s where things get fun. And there’s more than one way to turbocharge the already astounding effects of compound interest.

How To See Greater Returns

Several variables heavily influence how much compound interest your investment might see over time. The initial amount you put in, monthly contributions, anticipated returns, compound frequency, and time horizon all play a significant part. That means changing any of the variables in the right direction can pay in a big way.

  • Start young – The longer the time horizon, the more prominent effect compound interest will have. If you’re beginning to invest later in life and starting young is no longer an option, then it’s best to start as soon as possible. The more time you allow your money to grow, the better off you’ll be when you want to use it.
  • Make the largest initial investment you can – It may seem obvious, but a more considerable initial investment will guarantee larger returns over time. If you can do so, add as much money as you can to your account early on.
  • Contribute monthly– A lump sum investment will continue to grow whether you choose to make additional contributions or not. But to harness the earning power of compounding, it’s best to invest additional funds weekly or monthly.
  • Let it grow – It’s critical to let your money grow as long as possible. Know your investment’s purpose and begin to withdraw funds according to your plan, but not a moment sooner!

Is Compound Interest Ever a Bad Thing?

When it comes to savings, especially retirement savings, compound interest is your friend. But just as your investments make money off the money you earn, debt accruing compound interest happens in much the same way. If you have an outstanding balance on a credit card with a high monthly interest rate, subsequent interest charges will be based on the principal plus the previous month’s interest.

In this scenario, compound interest is a terrible thing and can make it incredibly difficult to dig out of a heavy debt burden. Some people try to combat this by making “interest-only” payments.

This is an effort to make sure they are only ever paying interest on the principal and is a way to make sure that the damaging effects of compound interest aren’t felt. But the best option overall is to avoid the pitfall of compound interest by creating a smart plan to pay off debt before it has time to manifest negatively.

All in all, compound interest is a blessing for your investments and a detriment to your debt. Understanding compound interest and how it can work for you is critical to leveraging it to reap the benefits of one of personal finance’s greatest treasures.

Contributor’s opinions are their own. Always do your own due diligence before investing.

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