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Compound Interest and How It Works 📈

The guide to making your money make money.

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What is Compound Interest? ✏️

Compound interest is simply the interest added to the principal amount of money that is invested or borrowed. The principal amount and the initial interest earned yield more interest over time, resulting in a compound effect. It is making interest from interest, which will eventually lead to enormous growth in interest — and subsequently, wealth. Compound interest benefits the investor, who will continue to earn money as long as their investment is not tampered with.

How Does Compound Interest Work? ⚙️

Let’s assume you deposited $1,000 in your bank account. And your bank offers you an interest rate of 10%/year. So, at the end of the year, you get $100 in the form of interest from your bank. That is, you now have $1,100 in total. At the end of the second year, your bank gives you another 10% as interest. Remember, you currently have $1,100 ($1,000 as your initial deposit and $100 as interest in the first year). Therefore, you will earn $110 in interest — meaning you now have $1,210. This is how your money will continue to increase exponentially every year, even though you don’t make any additional deposits.

Rather than calculating your interest based on the amount you deposited (or principal for short), compound interest calculates your yearly interest based on the initial amount you deposited plus the previous interest you have received from that amount.

This simply means that by the end of the 20th year, you’ll have $6,727 without saving any more money — that is, more than five times your initial deposit! This is how compound interest works, very enticing, isn’t it?

Below we put together a graph 📊 that lets you visualize the power of compounding interest. This example considers taking $1,000 and putting it into an investment account that earns 10%/year for 20 years. You can see by year 20, you’ll have made $5,727 just in interest, which is more than 5 times your initial deposit. The single best way to maximize the effects of compound interest is to start investing early and have time on your side. ⌛

Also, let us know in the comments if you like the graph! We can start using them more often if you find them valuable! 😎

A graph showing what 20 years of compound interest looks like on an initial $1,000 deposit.
Made with Google Charts.

The Compound Interest Formula 🧮

Have you always hated math and calculations, but you also wanna get wealthy? Well, if the concept of compound interest entices you, I’m sorry to tell you; but you may have to find a compromise with math. Because compound interest has its formula with which you can calculate your earnings after each year. Don’t worry; it’s not as complicated as the quadratic formula or those formulas you dreaded in school.

A = P(1+r/n) nt

The formula is that simple. But before you can apply it to calculate how much your bank will deposit in your account each year, you have to know what each symbol/letter represents.

P = Principal

r = the interest rate per annum, often written in decimals

n = the number of times in a year the interest increases

t = the time or time total number of years the interest will last

A = the total amount of money you will receive at the time the compound interest ends

It feels so lucky that you needn’t be a mathematics genius to understand this simple formula. I know, right? You can also use online calculators to calculate your earnings if you don’t want to use the formula. However, the formula gives a better understanding of how compound interest works.

Whether you are an investor or a borrower, you already know that (P) is the amount of money you have invested or borrowed within a particular period (t). In essence, these are two of the most essential variables to consider in determining your future earnings — your interest rate (r) and the frequency at which your interest increases (n).

The impact of your interest rate is very significant. A higher interest rate means you will earn more interest within a year, while a lower interest rate means you will make less. Simultaneously, the more interest you earn within a year, the higher your money goes (of course, assuming you’re an investor).

How Compound Interest Affects Debt 🏛️

Like earlier stated, compound interest only puts you in an advantageous position if you are the investor or lender. However, if you are a borrower, the reverse scenario occurs — it will work against you.

For example, many credit cards include rates with daily compounding interest. That is, your debts go higher and higher as each month goes by, without paying them off. This is the fundamental reason why paying off credit card debts can be very hard — and why you must try to pay off your debts at the end of each month. By doing so, the bank does not charge you for interests, and you wouldn’t bother about your debts compounding.

Putting Your Knowledge to Work 🎓

People who understand compound interest’ fundamental aspect tend to make smarter, strategic, and well-planned financial moves. For instance, you can save your money in banks that allow daily — instead of monthly or yearly — compounding and deposit money to the account as often as possible. On the other hand, you can also develop a habit of paying off your credit card debts monthly rather than rolling them over to the next month.

Take Advantage of Compound Interest 🔮

There are many ways you can take advantage of compound interests. Below are some of the most popular ones:

I. Save Early And Frequently: make great use of time when trying to increase your savings. That is, the more time your money is left untouched, the higher it increases. This is simply because compounding interests will grow exponentially over time. For example, if you deposit $200 every month for five years, at a 5% interest (compounded per month), you will have $12,000 in your account by the end of that timeframe.

II. Pay Off Your Credit Card Debts As Quickly As Possible: it will not be in your favor if you pay the minimum on your credit cards. It barely changes anything in the interest charges, and your debts will continue to increase. Such a move may likely come back to haunt you later.

III. Keep Borrowing Rates Low: apart from significantly affecting your monthly payment, the interest rates on your loans ascertain how fast your debts increase, as well as the time it may take for you to settle them. Most credit cards use a double-digit rate, and it’s hard to contend with. See if you can pay off several debts with a single loan. This may help decrease your interest rate, speed up paying off your debts, and help save you some cash.

Thanks for Reading!

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