What is compound interest and why should you care?

You’ll hear the term compound interest a lot when you’re researching things like credit cards and savings. But what is it and how does it work?

As understanding interest charges are key to a happy financial future, I’ll explain as much as I can.

I’ll cover compound interest for savings and for credit cards as those are the most common forms.

Compound interest with savings

When you save money in an account that earns interest, compound interest is your friend.

Here’s how it works:

1. Initial investment: You deposit a certain amount of money (called the principal) into a savings or investment account.
2. Interest accrual: Over time, the money in your account earns interest. With compound interest the interest doesn’t just get added to your initial deposit, it’s added to the total balance, including the previously earned interest. It ‘compounds’ what is already in the account.
3. Increasing balance: As time goes on, the interest keeps compounding, leading to a growing balance. This means your interest earns interest, creating a snowball effect.
4. Exponential growth: The longer you keep your money in the account, the more pronounced the growth becomes. This is why starting to save and invest early is often encouraged – the power of compounding can significantly boost your savings over time.

So basically, compound interest on savings is calculated on the total amount in the account, not the amount you initially put in there.

The longer you have savings, the more interest compounds, giving you more to withdraw at the end.

Compound interest with debt

When it comes to debt, compound interest can work against you:

1. Initial debt: If you carry a balance on your credit card (a form of debt), you owe the principal amount, and the credit card company charges interest on that debt.
2. Interest accrual: Like savings, the interest is added to the total debt, not just the initial amount you owe. This means that if you don’t pay off your full balance, you’re not only paying interest on the principal but also on the interest that’s already accumulated.
3. Growing debt: Over time, if you only make minimum payments, your debt can grow due to the compounding interest. This can make it difficult to pay off the debt, as the interest keeps adding up and increasing the total owed amount.
4. Paying off debt quickly: To avoid the pitfalls of compound interest, paying off your credit card debt as quickly as possible is crucial. The sooner you eliminate the principal amount, the less interest will accrue, ultimately saving you money.

Takeaway

In essence, compound interest amplifies growth, whether in savings or debt.

It’s a powerful concept that can work in your favour when saving and investing, but it can also lead to escalating debt if you’re not careful.

When it comes to debt, paying off the principal quickly is key to avoiding the effects of compound interest.

Remember, whether you’re saving or paying off debt, time is a crucial factor.

The earlier you start saving or paying off debt, the more impactful the effects will be. So, use this knowledge to make informed financial choices that align with your goals.