If an investment or loan accrues compound interest, its interest is calculated using the sum of its initial principal plus any previously accumulated interest. You can think of this concept t as “interest on interest” that will make your money grow faster than simple interest.
Suppose you deposited $100 one year ago in an account that compounds interest annually at 2%. Your first year’s interest would be $2, and the next year’s interest would be calculated from $102 rather than $100. Although this amount might not seem like much, compound interest can help you gain a considerable amount of money in the long run. The following are some helpful tips to help you make the most of this financial tool:
1. It’s Either Your Best Friend or Your Enemy
Compound interest can either be a beneficial or damaging financial tool; you either earn it or pay it. If you are collecting compound interest on an investment, you will gain more money than you deposit in the long run. However, if your lender charges compound interest, you will pay back more money than you initially borrowed.
Although most creditors use a simple interest formula, credit cards use compound interest. The interest you pay starts to accumulate from the first time you use the credit card to make a purchase. Luckily, some credit card issuers offer a grace period that expires after your due date, beyond which you will pay interest on the unpaid balance.
2. It Recognizes the Value of Time
It’s a financial fact that money invested grows with time, and money not invested loses value over time due to inflation. When you deposit money into a savings account accruing compound interest, it earns a set percentage of interest over a set period of time. Each period, the interest is then added to your initial deposit to make more interest. That’s the power of compound interest.
Money not invested will lose value in the form of interest it would have earned. In simpler terms, a delayed investment is a great opportunity missed. Start investing on accounts with compound interest now!
3. It Values Consistency
Consistency is essential to financial success. Without it, making progress is a struggle. Let’s consider two scenarios:
- Scenario 1: An investor makes an initial investment of $100 that compounds interest at 5% per annum. Since he understands the value of consistency, he adds small amounts of money to the initial investment every year.
- Scenario 2: An individual deposits $100 to his savings account; the amount compounds interest at 5% every year, and he doesn’t add any amount over the years.
When we compare both scenarios, the consistent investor in Scenario 1 made the best financial decision and will have more money after ten years.
4. Shorter Compounding Periods Are Better
Consider shorter compounding periods for your investment if you intend to make more money. For instance, if you invest $1,000, the interest earned will be more when compounded at 5% semiannually than a similar investment compounded at 10% annually.
5. It’s Better Than Simple Interest
When it comes to building wealth, compound interest is much more effective than simple interest. Besides earning interest on your initial investment, you make more money from the compound interest at the end of your compounding period. The period can either be annual, monthly, quarterly, or daily.
When used correctly, compound interest can be the key to your financial freedom. Now that you understand how compound interest works, use the information to your advantage. Start investing today and be consistent for a better tomorrow.