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What Compound Interest Is & Why You Needed To Utilize It Yesterday Thumbnail

What Compound Interest Is & Why You Needed To Utilize It Yesterday

We’re all really familiar with sourdough starter at this point in 2020, aren’t we? 

Well, compound interest is like a really great sourdough starter. The initial amount is like what you put in, and the beautiful effervescent bubbles that come with time is how the interest works for you over time. 

Perhaps this baking analogy falls a little flat (sorry, I had to). In that case, let’s consider the following few examples of compounding interest, and why it’s still better late than never to utilize it.

What is compound interest?

Benjamin Franklin put the fundamental idea of compound interest very simply; “a penny saved is a penny earned”. Or perhaps, more famously, “money makes money. And the money that makes money makes more money”.

That, ladies and gentlemen, is exactly what compounding interest is - your money making you more money. 

Compound interest is when the interest you earn on your balance in an investing or savings account is “re-invested”, thus earning you more interest.

When it comes to compound interest, time is your best friend. The earlier you start, the better your return will be. 

Is that to say you can’t start benefiting from compound interest if you’re “past the prime” (we all should have started in our 20’s or as soon as we started working!)? Definitely not. There’s no time like the present to start saving for your future.

Is compound interest only a good thing?

Sadly, no. We like to think about compounding interest only in the way it can work for you, but it can also hurt you. Think: credit card interest.

Compound interest isn’t a benefit when you end up borrowing money. The strategy for stopping it from working against you is paying down your debt as soon as you’re reasonably able to. 

You want your debts to compound as slowly as possible and your savings to compound as quickly as possible. If you think you have to carry a balance for a while, try to at least negotiate the rate of compounding if possible. 

Why? The more often the interest compounds, the more you’ll end up owing. 

What is involved in compound interest?

There are a few key things to understand when it comes to compound interest and how it’s “made up”. 

The Starting principal is how much money you start out with. As compounding occurs over time, it’s all based on how much you deposited to begin with (or, in the case of debt, how much you initially borrowed).

Interest is the rate you earn on your starting principal, and the higher it is, the more you earn (or again, in the case of debt, how much interest is charged). 

Frequency of compounding is the speed of how interest is compounded (monthly, annually or even daily). 

Duration is how long you intend on keeping the principal amount in your account (or how long it’ll take you to pay off what you’ve borrowed). The longer you keep it in that account, the more you’ll make (or owe). 

Example 1: You open a high interest savings account with a starting principal of $10,000. The interest rate is 5% and the frequency of compounding is monthly. The duration you plan to keep your investment in is 15 years.

Example 2: You open a credit card with an interest rate of 11% on all charges and cash back. You immediately put a starting principal charge of $5,000 on it. The frequency of the compounding interest is monthly and the duration you intend to carry the balance is 6 months. (only exception to this would be interest-free offers of balance transfer offers).

What’s a real life example of simple interest and compound interest?

Always open a compounding interest account if possible, and here’s why.

Imagine you have a starting principal of $2,000 in a savings account that earns 5% interest that compounds annually. You plan to keep it in your account for 10 years. 

At the end of the first year, you would have earned $100 just for keeping it in there. That $100 is then added to your starting principal of $2,000, giving you $2,100. In year 2, you’d end up earning $105, which is then also added to the principal amount. Every year you earn more interest as the balance increases. Of course, the more you add into the savings account, the more the compounding interest will work for you. But, if you never touched it, you’d still earn more interest every single year. 

A simple interest account just doesn’t do that. Using the same numbers as above, a simple interest account would just give you that flat 5%.

Your interest earns interest in a compounding account. There’s never time like the present to start putting the clock on your side.

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