It was probably in 7th or 8th grade that I first studied about, Interests, Profit and Loss.
Back then all that I was interested in, was Simple Interest. For, it was easy to memorize the formula, easy to understand, and good for scoring marks.
The part that I really avoided was compound interest. Why? Cause, that was way complicated for my little brain to grasp, man!!
But, with time I started to understand the power of compounding, and nowadays, all I look for is, which investment tools and bank accounts offer compound interest.
Because, that’s how you can make a profit, and that’s how you will amplify your wealth. Compounding is the key to elaborate your finances, I can keep on telling you that forever!!
# What is the compound interest and how does it work?
You must be hearing it everywhere that compound interest is all about gaining interest on interest.
A part of it is quite true. It’s actually, however, adding interest on top of (interest + the principal amount).
But, ‘simple interest’ is the first step that compound interest contains. It’s always better to understand stuff with an example.
Let’s say you deposited some $200, in your savings account, that earns 2% interest per month (I know it’s quite hypothetical, but let’s stick to it), on a compounded basis.
That means, for the first month, your account gets a ‘simple interest’ of $4. It’s the general simple interest formula that you apply, (P*R*T)/100, where P is the principal, R is the rate of interest, and T is the term, or time, or duration.
The game changes from the next month, where again we will use the same simple interest formula, but the principal amount will become $204, instead of $200. And, that my friend is the magic or power of compound interest.
So, you can pretty well say that compound interest is made of a series of simple interests, where the principal amount will start to increase, with time, due to the accumulation of interests.
# How can compound interest help to improve your financial life?
Compounding is what makes an investment so much fun. If money only got a fixed return, then investment will only see darker days!
Consider any retirement investment vehicles, like IRAs or 401(k)s; they all run on compound interest formats.
You might be doing your monthly or yearly contributions to these accounts, but the interest is also getting added up to the principal amount as months and years pass.
And, that’s truly why, experts say, time is the most valuable factor in investments.
In the most general sense, more the interests get added up to your base value, more will be the return on investments.
But it might not be the same with Certificate of Deposits. Fixed deposits work a bit different from other investment tools.
If you plan to invest in a Certificate of Deposit, for a single term, then the maturity value is calculated in simple interest.
On the other hand, when you keep this CD, for more than 1 term, then it will start to get compounded, on a regular basis, by the end of each term.
A term means a certain time period. In one time period, interest will be gained only once. This term could be anything starting from 1 day to anywhere in years. But, more frequently interest gets added, more will be the investment value.
Therefore, to get the most out of investments, sit down with an advisor and look for vehicles that have shorter interest terms and work on compound interest. That’s because interests should get added to the principal amount pretty often.
# How can compound interest ruin your financial life?
I thought it over and over, to be sure, whether or not to include this section in the post. Because this part is pretty depressing to look at.
But, it’s important for you to know!
So, who is it, that benefits from the magic of compounding? Obviously the investor!
Now, whenever you are taking out a loan or use credit cards, these become investments for the creditor.
Well, well, that means they will definitely look into it, that their investment also sees a bit of compound interest, just like you are getting in your savings and retirement accounts.
Therefore, you should definitely be aware of credit cards and how they function! These cards accumulate interests on a daily basis; at least most of them.
And, this is compounded!
Thus, any missed payment will result in more payment later on.
Compound interest is undeniably a very profitable aspect when you are the investor. And, it is equally disastrous when you are the debtor.
Therefore, try to avoid missing out payments, especially on credit cards! Don’t let the power to be in your creditor’s hand.
Compound interest is power!
Power to you!