If you have any credit card debt, personal loans, retirement accounts, or other investments, compounded interest is probably affecting your money, either for good or for bad. Compound interest can affect your savings or debt by thousands of dollars, but many people don’t understand how it works.
When you understand why making minimum payments on your credit cards or loans is a bad idea, and why choosing investment accounts with higher compounding interest rates is a good idea, you may find it a little bit easier to change your spending habits. A major factor in personal financial success is understanding compounding interest, maximizing its benefits, and eliminating or reducing bad compounding interest. Let’s check out how that works.
What is Compound Interest?
With compound interest, you earn interest on the principal balance of your account and any interest already earned. In comparison, simple interest only earns interest on the principal balance.
Let’s look at an account with a balance of $100,000 earning 10% yearly and see what a difference compound interest can make. Year zero consists of the principal balance only. This chart assumes you don’t ever add any extra money to that initial $100,000. It also assumes a consistent interest rate the entire time. You can check your numbers on this compound interest rate calculator.
|Simple Interest||Compound Interest|
In the “Simple Interest” column, you can see that each year, you earn 10% interest only on that initial $100,000 principal balance. In the “Compound Interest” column, each year you earn 10% interest on the entire balance of the account—including any interest you’ve earned in previous years.
As you can see, compounding interest makes a major difference, particularly when applied over a long period. The reason this happens is that compound interest earns interest on more money than simple interest.
Most accounts either compound daily or annually, though some savings accounts also compound quarterly.
How Compound Interest Can Hurt You
If you have a credit card, auto loan, student loan, or personal loan, the odds are that your interest rate compounds daily. The daily amount may seem minuscule, but it adds up quickly.
Let’s assume you have a credit card with a $5,000 balance and an interest rate of 19%. Your daily interest rate (19% divided by 365) is .00052. Multiply that number by your average daily balance (in this example $5,000), and you’ll see that you’re accruing an additional $2.60 in debt every day, even though you aren’t spending any more money.
Multiply that by the number of days in the billing cycle (30). Your total monthly interest accrued is $78. If you’re making minimum payments, and not making any additional purchases, it’s still going to take a long time to pay off your credit card. In this case, if you made a payment of $100 each month, it would take eight years to pay off that debt, and you’d pay a total of $9,985—nearly twice what you spent on the card!
In the case of debt, compounding interest can significantly increase how much money you pay a lender.
According to Nerd Wallet, the average household has about $135,768 in debt (including a mortgage). The study also showed that the average American carries a balance of $6,929 on their credit cards, $47,671 in student loans, and $28,033 in auto loans. When you factor in compounding interest, each of these added up can cost you a ton of money over time.
How Compound Interest Can Help You
Compound interest can be a benefit too. Like we showed in the chart above, simply investing in an account with compounding interest versus simple interest, can prove fruitful over many years. If like most people, you don’t have $100,000 to toss into a compound-interest bearing account, but you can still take advantage of compound interest by regularly contributing.
Let’s say you begin with an initial investment of $1,000, and you contribute $250 a month for the next 30 years at a 10% return (we’ll keep the interest rate flat, to make the math simple), compounded annually. At the end of 30 years, your savings will have grown to about $510,931.47. Like all good things, time is a major component of a successful financial recipe, especially when it comes to earning money off interest.
Compounding interest takes a little math, but the concept is simple. When you learn how to maximize the benefit of compound interest by making smart investments and reducing the negative effects by paying off debt faster, you’ll be able to take better control of your financial future.