The power of compound interest is way underrated. This is because most people find it hard to deposit a principal amount only to receive the accumulated interest. Tracing its roots to 17th century Italy, it’s simply “interest on interest.”
Basically, it is calculated on the principal amount and grows the sum amount at a more rapid rate than simple interest. One of the unique points of compound interest is the fact that its accrual is pegged on the frequency of compounding.
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Most people don’t like numbers unless they are being added to their checks. So we are going to make the power of compound interest and why you should start saving now as easy as possible to understand.
First, youneed to know how compound interest is calculated
Compound Interest Equation
A = P(1 + r/n)nt
Ø A = Accrued amount
Ø P = Principal amount
Ø I = Interest amount
Ø R = Percentage annual nominal interest rate
Ø r = Annual nominal interest rate
Ø r = R/100
Ø t = Time involved in years
Ø n = Number of compounding periods
How often is interest compounded?
Various financial instruments have different compound interest frequencies. For example, a savings account is compounded on a daily basis, while a certificate deposit can be compounded on a daily, monthly, or semi-annual basis. Home equity loans and credit cards are compounded monthly.
All these are possible scenarios for compounding frequency. However, another important note is that these variations can be reflected in the accrued interest. This is because the accrued interest is credited on the actual existing balance. This interest can be compounded on a daily basis, but can only be credited at the end of the month.
There are some instances where some creative banks have decided to modify the concept of compounding interest. They do offer continuous compound interest. This is added to the principal amount at random instances. To ensure that it’s practical, the interest doesn’t cumulatively go beyond the daily compounded interest.
The benefits of compound interest
The real secret of compound interest lies in the time value of money. Money isn’t “free” and has a cost that comes in form of interest payable. You may remember the all old saying that says: “A dollar in the hand today is worth more in the future.”
For instance, if you have $200 today and decide to keep it in liquid form rather than invest it, the purchasing power will obviously decline. However, if you invest the amount or deposit it in a savings account, you will earn interest that’s pegged on the prevailing inflation rate.
Compound interest also helps you grow exponentially by sheltering you from potential wealth erosion factors like inflation and the high cost of living.
What does this tell you? The earlier you start investing, the better.
One of the best ways to squeeze more out of your investments is a mutual fund. This is because they are flexible enough to allow you to re-invest the dividends you derive from your initial investment by buying additional shares in the fund. As this cycle continues, you continue expanding your compound interest.
When does compound interest become your enemy?
Although the power of compound interest can tilt the playing level to your advantage, it can also prove hard to balance, especially if you have a credit card debt that carries high interest. If for example your credit card balance is $20,000 and carries 20 percent interest rate that is compounded monthly, your total annual compound interest would be around $4,388 or $365 per month.
The take home
If you are just starting off in your career, chances are that you are faced with different factors competing for your small salary. However, you can make the wise decision and invest in any compound interest oriented investment to hedge your financial future. If you are planning to be a parent, leverage the power of compound interest by saving once the child is born.
Dan Chabert — Writing from Copenhagen, Denmark, Dan is an award-winning web lover and the co-manager of several sites for your house needs and others. You can check these out That Sweet Gift, Contractorculture, The Gear Hunt, and Runner Click. He is a travel scholar time a health Enthusiast.