Compound interest is considered by some to be the eighth wonder of a world, and for good reason. It can be a hard concept to understand at first, but it's actually fairly simple. Unlike simple interest, this interest grows on top of the interest already earned until that point. This means that calculations using compound interest will grow faster than simple interest.
How does compound interest work?
It's magic. Not really, but it can seem that way. Essentially, compound interest is money that accumulates interest on any already accumulated interest. The interest can compound at different periods, ranging from daily to yearly (or later). The rate at which it compounds is when the interest that accumulated will become part of the balance and start earning interest as well.
You have $1,000 growing every year at 10% and it compounds yearly, for example. After one year, you would earn $100 and have a total of $1,100. Now you would start earning interest at $1,100, instead of just $1,000. This means that at the end of year two, you will earn $110 and have a total of $1,210. And this compound effect will continue, until after 10 years, you accumulated $2,593.74, more than 2.5 times what you started with.
How compound interest can be good for you
This kind of interest can be good for you when you're investing your money. In investing, compound interest means that you're not just making money on your initial investment, but also the accumulation of any returns. This is like the example that is shown above. Basically, you will continue to earn more as your investment grows, compounding over time.
Make sure you start investing today to maximize your return. The earlier you start, the earlier you will start earning and experiencing compound growth. It's important to take steps and start today if you can. You can also earn compound interest from savings accounts. A high-yield savings account could earn you more interest than a traditional account.
How it can hurt you
This type of interest can also be harmful to you depending on the situation. When you have debt, the interest can pile up quickly and leave you drowning. In fact, most loans will compound the interest daily, making your balance grow even quicker.
While taking out loans may be necessary to make some big purchases, it can come back to haunt you. Compound interest can make you spend well over 1.5 times what you purchased an item before. Also be weary of high-interest debt, such as credit cards or payday loans. The interest on these types of credit can accumulate quickly and leave you buried in debt.
If you're currently struggling with compounding interest from student debt, check out Defynance. Our interest-free solution is based on income share agreements, which allows you more freedom to live your life.
