What is Compound Interest
Whether you are taking out a loan, or placing your money into a bank account, you will be dealing with interest and interest rates. This will mean you will be calculating the cost of various things and that’s particularly important when you are choosing banks to invest your money in or when you are choosing lenders to borrow from. In the case of banks you want high interest, where in the case of loans the best interest rates will be low interest.
It’s a complicated process though understanding your interest rates and there are a lot of factors involved in the interest. Thus you will likely hear many financial and mathematical terms when you are thinking about your interest and among these will be the term ‘compound interest’. Understanding compound interest isn’t innate, but it is very valuable if you hope to be able to calculate the value of your loan or the worth of a bank account. Here then will look at what compound interest means and bring you back up to speed.
Essentially, compound interest is cumulative interest that increases over time. The reason this occurs is because the interest earned is added to the ‘principle’ (AKA the initial lump that you put in there). Thus this then means that any future interest is calculated taking into account the extra money you have earned.
So for instance imagine you put $100 into a bank account or building society that offers you 2% APR (annual percentage rate); by the end of the first year you would have earned an addition $2 because that’s 2% of 100. However this $2 would then be added to the principle $100, so the next year’s interest would be on $102. 2% of 102 is 2.04, so you would by the end of the second year have $104.04 in your account. That .04 of a cent might not seem like much, but it is then added to the next year’s interest too and essentially this means that your money will grow exponentially and it is more than worth the investment.
When you chart this interest out on a piece of paper what you end up with is a line that curves slowly upwards and gets steeper as time goes by. This then mans that your money will grow the fastest and the best if you choose an account with compound interest. If you take out a loan however this compound interest is not always going to be relevant – as the amount of money in the ‘pool’ decreases over time rather than increases. Where it is relevant is in credit card interest. When you are late paying your credit card, then you will have more to pay back, and where the interest is compound it will then begin to gain momentum and speed. This is how many people get themselves caught in debt and end up unable to get out.
When you take out a loan or invest your money it is important to work out your compound interest and you can do this with a compound interest calculator. A compound interest calculator will allow you to input your money and time, and this will then tell you how much interest this will add up to over time.
Understanding compound interest is important for your financial health. Visit the links for a compound interest calculator.
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