Tom Koziol explains how compound interest can make you a much better saver--or plague you with rapidly spiraling debt--depending on whether and how you're investing or borrowing. Compound interest can multiply your wealth--or keep you in poverty.
It is reported that Albert Einstein called compound interest the ninth wonder of the world and Ben Franklin extolled the virtues of compound interest to anyone who would listen.
OK, but what is compound interest?
Compound interest means that interest is paid not only on the principal (initial loan balance), but also on the interest it earns. It's simply wonderful if you are on the receiving end. Absolutely horrible if you are on the paying end. This article will give the math. You determine on what side of the compound interest equation you would like to live.
I'll use the industry standard example of $1,000 at 5 per cent, compounded annually for this example. Be advised, however, that compounding also happens on a more frequent basis. Some money market funds, for example, pay interest daily and some savings account pay interest daily but credit the interest quarterly.
Note: Always check with the financial institution for the exact details on how they pay and credit interest to your account.
$1,000 at 5% produces $1,050 after year one. At the end of year 2, the amount in the account is $1,102.50. After year 3, the account grows to $1,157.63.
The interest is always paid on the balance. This means at the end of year two, the bank multiplies the $1,050 (balance in account after year one) by 5%‹producing $52.50‹then adds the 52.50 to the $1,050. At the end of year 2, the 5% is multiplied times $1,102.50 and added to the $1,102.50, giving a new balance of $1,157.63. And on and on and on it goes.
If that $1,000 you deposited in year one received that same 5% each year for the next 25 years, you will have $3,481.29 in your account assuming no withdrawls.
That's all there is to it. Of course, having the $1,000.00 to begin earning the interest may be a problem. Guess what? Compound interest has no minimum on which it will pay. That's right, if you have only $100.00 to deposit, deposit it.
Get started today reaping the simply wonderful benefits of compound interest.
That's the receiving end. The "good" end. What about the paying end?
Look at the numbers again but imagine those dollars are flowing out of your account. That's right. Year after year, your creditor gets to take that amount from your account until your debt is paid.
Of course, the dynamics of the loan will vary per loan but essentially your account goes one way. Down!
[Editor's note: Compound interest is why you should pay off your credit cards, in full, every month.]
Always check the contract so you know the term, interest, payment, length, amortization schedule of the loan and prepayment penalties, if any.
There you have it. The two sides of compound interest.
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