What Is Compound Interest? The 6 Minute Guide
What is compound interest? The idea of compounding interest might sound complicated, but it’s actually easy to understand! Find out more in this quick guide. Warren Buffet, the world’s leading investor, refers to compounding interest as an investors’ best friend. The longer you let it grow, the more interest you can earn.
How to Compound Interest
Compounding interest is a powerful tool that can help you grow your wealth over time. It essentially refers to earning interest on your interest, which can help your money grow at an exponential rate. On the flip side, it also refers to when you take out a loan and you’re paying compounding interest. Our advice is to pay off any finance agreements you have as fast as possible. In New Zealand and many western countries, there are lending codes that keep lenders honest, but debt can still run away on you if you don’t keep your eye on it.
There are a few different ways to compound interest. When thinking about stocks, one way is to simply reinvest your interest earnings back into your original investment, which grows your interest earning capability. This will allow you to earn interest on your original investment, plus you’re now investing with what you’ve earned. You can also diversify your portfolio and purchase new stocks with your earnings.
What is compound interest when it comes to loans? Interest is calculated daily. Down pay your loans as fast as possible, and make sure you put as much of a deposit down initially as feasible. Your interest charges will compound over time, and those who take mortgage holidays or missed loan payments might find that they never get out of debt. Not all lenders are equal when it comes to rates and fees, so if you’re looking for a personal loan, it’s advisable not to just take the easiest option.
The Formula
What is the compounding interest formula?The basic idea behind compounding interest is simple: you earn interest on your original investment, plus any interest that has accrued in previous periods.
To calculate compound interest, you need to know three things: the principal (the amount of money you are investing), the rate of return (the interest rate you will earn on your investment), and the number of compounding periods (typically per year).
The formula for compound interest is: A = P(1 + r/n)^nt
where:
A = the future value of your investment
P = the principal (the amount of money you are investing)
r = the rate of return (the interest rate you will earn on your investment)
n = the number of compounding periods (typically per year)
t = the number of years you plan to invest for
For example, let’s say you invest $10,000 at a 10% annual return. If we assume that interest is compounded monthly, then we have n=12 and t=10. Plugging those values into the formula, we get: A = $10
Examples
Compounding interest is when you earn interest on your investment, and then you reinvest that money and earn interest on the new total. This process continues, and your money starts to grow at an exponential rate.
For example, let’s say you have $100 in a savings account that earns 4% interest per year. After one year, you will have $104. And then the next year, you will earn 4% interest on $104, which becomes to $112.48, and the following year it becomes $116.98. As you can see, your money is growing at an accelerating rate. Fast forward this ten years, and suddenly you’re earning $173.16. Your initial $100 is earning you $73.16 per year, and that’s without reinvesting the earnings.
Compounding interest can work for you or against you. If you owe money on a credit card with a high interest rate, compounding interest will cause your debt to grow quickly. But if you’re saving for retirement, compounding interest can help your money grow much faster than it would without it.
Advantages and Disadvantages of Compounding Interest
There are both advantages and disadvantages to compounding interest. On the plus side, compounding interest can help you earn more money on your investment over time. This is because you not only earn interest on your original investment, but also on the interest that has accrued. This can result in a snowball effect, where your investment grows larger and larger over time.
However, there are also some disadvantages to compounding interest. One downside is that it can take longer to reach your financial goals if you’re relying on compounding interest. This is because it takes time for the interest to start accumulating. Additionally, if you have a debt with compounding interest, it can become very difficult to pay off. The interest will continue to accrue, making your debt larger and larger over time.
What Is Compound Interest – Summary
All in all, it’s a way of growing funds exponentially. You need to be patient, for the results become in the initial stages, your gains might seem small. As your investment size grows, the profits grow proportionally. The best way to work out what compounding interest is, is to create a spreadsheet based on the simple math above and reinvest all earnings into your formula. You might be shocked by the results.
