Many people learn about finances through experience. Gradually, they’re introduced to new concepts and milestone information they need to grow. Like what type of savings account would suit them best or which bank they should even go to in the first place. But out of all the knowledge you collected over the years, what would you say is the most important? Surprisingly, many who work in the banking industry argue that compounding is the most vital thing every consumer should know.
What is compound interest?
When learning, it’s always good to start with the basics. So, if you ask Merriam-Webster Dictionary for the definition of “compounding,” it answers: “interest computed on the sum of an original principal and accrued interest.” If that was just a bit too technical, don’t worry. We can break down the idea.
In essence, compounding has everything to do with interest and its impact on debt. If debts are in repayment mode, interest continues to build, and the cost of goods and services purchased with credit goes up. For example, suppose your interest gets automatically calculated into a monthly payment for an auto loan. In that scenario, we often fail to notice the amount of monthly interest we’re paying in addition to the principal cost of the car.
Suppose interest is accruing or adding on to a credit card or revolving debt. In that case, it can make it challenging to get ahead of that particular debt because the interest on the current balance goes up every time the credit card balance increases. It’s a terrifying situation. Because of this, it’s sometimes wiser to pay off credit cards monthly. Or wait until the cash is available to purchase what we want or need
Compounding doesn’t only impact financial decisions and the reality of debt. It can also be a positive thing for those who start saving and want to watch their money grow due to layered interest and dividends. Interest built on deposits and already accrued interest is the foundation for growing wealth.
Why compound interest matters?
Compounding is the most important financial concept a consumer can ever learn. That’s because once that concept sinks in, it makes it harder and harder for consumers to ignore it. They have to pay attention to the dangerous compounding which more and more debt can cause.
Conversely, it makes it easier to buckle down, pay off debt as soon as possible, and take those new-found resources and turn them into deposits that will continue to positively compound and build lasting financial security.
Example of compound interest
The formula for compound interest looks like this: Initial Balance*(1+(interest rate/number of compoundings per period)^number of compoundings per period*number of periods
Let’s say you have two savings accounts with $200,000 in each. Both pay the same interest rate at .55%; however, one compounds annually. The other account compounds monthly.
For the account that compounds interest once a year, if you take out the money after a year, you receive:
$200,000*(1+(.0055/1))1*1 = $201,100
For the account that compounds interest monthly, if you take out the money after a year, you receive:
$200,000*(1+(.0055/12))12*1 = $201,102.77
Over time, the impact of compound interest becomes bigger and bigger. That’s because you’re earning interest on the combined principal and additional interest already built up.
Simple interest vs. compound interest
Don’t get confused, but compound interest isn’t the only kind of interest out there. There’s also simple interest and, like its name, it involves just a little less math. That’s because simple interest doesn’t change or vary over its life.
Instead, it’s calculated only according to your original principal, whether that was the amount you put into the bank or borrowed from it. Because of this, it applies as a permanent, fixed rate. So, no changing or building on the accumulated interest.
As you know by now, compound interest works differently. It takes the principal in addition to the accumulated interest to create a variable, or non-fixed, rate. Then, interest packs on top of interest, giving you a leg up on your journey to achieve your financial goals.
Compounding interest is a powerful tool. But knowing how to use it to your advantage will help you even more. If you want to increase your wealth, start saving early. The sooner you put your money in an account, the longer it has to build up interest. So, more compounding can occur – meaning you make out with steadily growing wealth.
If you want to maximize these earnings, always look for the annual percentage yield (APY), and the frequency of compounding. Together, these details can indicate the type of financial outlook your savings account may support.
Remember, though, that compounding can hurt just as much as it can help. Ensure that your own debts with high interest stay low or regularly paid. Thus, minimizing and killing any potential cycles of debt.
If you want further guidance, consider speaking to a financial advisor. They can guide you to the right savings tool for you and help you navigate out of harmful credit situations.