On a scale of one to ten, with ten being high, how would you rate your understanding of compound interest?
Have you ever heard the old saying, “Knowledge is power”?
In the case of compound interest, the more knowledge you have, the more power you possess.
As I was mentally preparing for this post, I had a completely random conversation with a friend.
Several years ago, she was fortunate enough to come into a small amount of money. Since receiving it, the money has been hanging out in her savings account, waiting for a rainy day.
Time has a way of slipping by and, still not having a definite purpose for the money, she decided it was time to move it to an investment account.
During the first month in the investment account, she earned one hundred and eight dollars in interest.
While she was happy with the interest she earned, she was ill about the literal thousands of lost dollars.
When compound interest is involved, invest sooner rather than later. Time really is money.
What is compound interest?
The simplest explanation for compound interest is when you earn interest on both the money you’ve saved and the interest you earned.
In the case of my friend, during the second month of the new investment, she earned interest on both her initial investment and the additional one hundred and eight dollars.
Compound interest, when working for you, is a pretty sweet deal.
Is the annual percentage rate important?
The annual percentage rate, while important, doesn’t tell the whole story.
How often an account compounds has a significant impact on the earning power of the annual percentage rate.
How often do interest bearing accounts compound?
Although every account can vary, most accounts typically compound annually (once-per-year), quarterly (four times per year), monthly or even daily.
The frequency of compounding will determine future earnings, and when investing the more often the account compounds the more money you will earn.
How long does it take for your money to grow?
While you will see immediate results pretty quickly, to enjoy significant growth, it will take several years.
That’s the reason it’s so important to start saving for retirement as early as possible.
The longer the money sits in an interest bearing account, that regularly compounds, the more money you will make over the course of several years.
Is compound interest ever a bad thing?
Yes, and yes and yes!
As amazing as compound interest is, it’s a disaster when it’s working against you.
The majority of credit card issuers compound interest daily based on the average daily balance.
For any unpaid balance after the end of the billing cycle, interest is calculated daily and added to the outstanding balance.
At the end of every single day, the new, higher balance continues to compound, often resulting in crippling debt.
Compound interest is the reason that many people find it difficult to climb out of credit card debt.
Compound interest is one of those key financial concepts about which every adult should have a basic understanding.
In the words of Albert Einstein; “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t…pays it.”
Take steps sooner rather than later to make sure you are earning it and not paying it.
Would you like to experiment with the potential of compound interest?
Check out this compound interest calculator. Seeing is believing!
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