What is compound interest ?

The Good Side of Compound Interest

Compound interest is interest that is paid on interest. Basically, it’s money that you receive on your returns. If you have a savings account that pays in compound interest.

If your account paid simple interest, and you added nothing new, your next interest payment would be the same, until at the end of the year you had, With simple interest, your earnings are only on your principal.

Compound interest changes things up. You receive interest on your interest earnings as well as your principal. 

Where compound interest really helps, says Steven Elwell, CFP and vice president at Schroeder, Braxton & Vogt, is when you use it over the long term. “It’s not too powerful over short periods of time,” he says. He also points out that you should invest some of your money, rather than put it all in a savings account.

Compound interest is more useful when you put your money into things that have the potential to earn over time. “Look to investing in stocks and bonds with higher dividends and potential growth,” says Elwell.

And the earlier you start, the better off you’ll be. “No amount of money is too small to start saving,” Elwell says. “You need to start as early as possible to maximize the effect.”

“Most people don’t fully understand the long-term effect of compound interest. The most important variable for compound interest is the length of time for the interest to compound,” says Elwell. “This why it’s so much easier to save for retirement if you start in your 20s as compared to your 40s. Imagine earning dividends on your dividends’ dividends.”

The Bad of Compound Interest

Most people think of interest in terms of what they are paying, however. And it can, indeed, be problematic. This is because when you’re paying compound interest, it is equally powerful as it’s holding you down and making it difficult for you to get ahead financially.

One of the issues that you run into with paying compound interest is the fact that often it is compounded daily — particularly when you have credit cards. You might only have your interest compounded on a savings account or other investments once a month, once a quarter, or once a year. (There are some savings accounts that compound daily, and some dividends pay quarterly, so compound on that basis.)

The more often interest is compounded, the more you earn — or pay. With credit cards, the problem is, er, compounded by the fact that the annual rates are often so high. 

“This causes big problems with long-term credit card debt,” Elwell points out. And you can see how carrying balances over time can start to really make a dent in your finances. “The effects of compound interest can make poor spending and budgeting habits worse over time,” Elwell continues, “and can lead to bankruptcy.”

If you don’t keep a lid on your debt, and you are on the paying end of compound interest, it’s difficult to build wealth over time, since the effect of high-interest debt compounding daily can cancel out the effects of the interest you earn on investments over time.

So, if you really want compound interest to work for you, it makes sense to pay off your high-interest debt as quickly as possible (or avoid it altogether if you can), and then start investing right now.

Source secondary