WHAT IS COMPOUND INTEREST?
What is Compound Interest?
Compound interest is a powerful tool and a key part of growing wealth. Simply put, compound interest is the interest you earn on interest.
For example, if invest $100 today at an annual interest rate (APR) of 7%, in one year you will have $107. You just earned $7 in interest.
The next year, you begin with $107 invested at the same 7% APR, which will give you a total of $114.49. Now you earned $7.49 in interest.
The amount of interest you earn increases, without investing any more money. Your interest gained interest. Now imagine this idea with thousands or millions of dollars…it can be pretty magical.
However, it’s not always this good to be true. Compound interest also applies to debts as well.
Compounding Interest on Debts
Certain debts are subject to compound interest, where you pay interest on the principal (the amount you originally borrowed) AND any accrued interest.
The most common form of debt with compound interest is credit card debt. Have you ever wondered why it feels nearly impossible to pay off credit card debt? Let me explain.
Let’s say you have a balance of $1,000 on your credit card that has an APR of 16%, and you can’t pay it off by its payment date.
That $1,000 is going to begin accruing interest and start compounding daily. This means your debt will start accruing daily interest, and your daily interest rate is your APR divided by 365. In this case, this debt would be gaining daily interest of about .00044%.
Your balance today is $1,000. Your balance tomorrow is $1,000.44, then $1000.88 the next day, and so on. After one month, your balance would be $1,013.42,and after one year, your balance would be $1,173.47.
Your initial $1,000 balance has gained $173.47 in interest over one year, without you spending any extra money. Compound interest is a snowball effect that makes it nearly impossible to crawl out of debt.
Credit cards are a great financial tool, but it is important to be smart and pay your balances in full each month to avoid getting this crippling compound interest.
Using Compound Interest to Build Wealth
Now that we’ve provided the disclaimer about the negative sides of compound interest, let’s get into the exciting part! Compounding interest allows your money to grow at an accelerated rate, but how exactly can you receive these benefits?
There are several ways you can invest your money to utilize the effects of compound interest. Below are the most common compound interest investments.
High-yield savings accounts
Money market accounts
Certificates of Deposits (CDs)
Bonds
Mutual Funds
Don’t just let your money sit in a traditional savings account with a 0.05% interest rate. Try out these low risk investments and see your money grow!
