How does compound interest work?

You’ve probably heard the term “compound interest” before, but do you really understand how it works? Otherwise, you’re in good company. In a FINRA Foundation financial literacy study, only one-third of Americans could accurately answer a question about compound interest payments. Yet understanding this concept is key to making sure your financial habits are working for you, not against you.

Take investing for retirement, for example. Compound interest is why we benefit from getting started as soon as possible: your first investments generate interest income, which results in a higher investment for the next interest period. This cycle continues so that the interest you earn is continually calculated based on a new, higher amount, as it includes the interest already earned. Basically, your interest earns interest, which earns more interest, and so on.

So composition is a good thing?

When it comes to your savings and investments, compounding is definitely a good thing. (Savings accounts also operate on the compound interest model, but current rates are far lower than you can reasonably expect from the stock market.)

“As an investor, compound interest is the fastest way to grow your money,” says Bryan Bibbo of The JL Smith Group in Avon, Ohio. “With compound interest, on a long-term investment, you could put a much smaller amount in at the start and 25 or 30 years later end up with a huge sum. It’s basically the idea that your money should work for you.

But that doesn’t mean making an investment and then stopping.

Making an investment in a compound account and leaving it alone can lead to steady growth over time, but that’s not the right approach for true investment growth. “Investors should keep in mind that for compound interest to work, it needs to be fed,” says Bibbo. “While you can make a significant return over a long period of time with just one investment, to take full control of the potential of compound interest, investors must get into the habit of saving and contributing consistently at every given opportunity.”

Successful long-term investors look to products that offer compound interest. Look for the APY, or annual percentage return, which is the total return you will earn over one year. Bibbo recommends looking for investments with the highest return and the most compounding periods.

What about when you borrow money?

Well thought. If you owe money, compounding can work against you in some cases. Some types of debt, such as home loans, auto loans, and student loans, use simple interest. This means that you pay the same amount of interest per month.

But other types of debt, like credit card debt, use compound interest. If you have month-to-month credit card debt, you’re not just paying interest on your most recent purchases. You also pay interest on interest charged in previous months. And that can add up quickly.

Let’s say you owe $3,000 on a credit card with an annual interest rate of 18%. When this annual rate is divided into 12 monthly installments, it means that each month your card balance accrues 1.5% interest. Since credit card interest is calculated daily (as opposed to weekly, monthly, or yearly), you are charged approximately 0.05% per day for this balance.

If you skipped a payment in January, for example, your interest in February will be determined based on the higher amount of $3,045. Even if you don’t skip payments but only pay the minimum $100 a month, it will take you nearly three and a half years to pay off the balance and you’ll be shelling out over $1,000 in extra interest.

The annual percentage rate (APR) is the amount you will pay in interest over a year: if you divide the APR by 365, you will get the daily interest rate. Most credit cards calculate interest daily on any balance not paid by the due date. Thus, unpaid interest on past charges accrues daily. To make matters even more confusing, different types of credit card debt (like purchases, cash advances, and penalties) can have different interest rates, which accrue at different times.

As a borrower, look for the lowest rate with the fewest compounding periods. “Borrowing with compound interest has the potential to slip away if you’re not careful,” says Bibbo. “The idea here is to pay off that debt as quickly and reasonably as possible to keep interest in check.”

Why is compounding so hard to understand?

Many people have a hard time understanding how compound interest affects them because many common uses of interest in personal finance use simple interest. Because home loans, auto loans and student loans all use simple interest, it reinforces many people’s experience of how interest works, says Bibbo. Additionally, lenders often use unfamiliar terms (like APR, or annual percentage rate, and APY, or annual percentage yield) to promote credit products, and consumers often choose what sounds good even though the concept is trouble.

To benefit both as an investor and as a borrower, it’s essential to understand the mix, says Bibbo. If the interest on your investment is compounded, your money is working for you, but if the interest on the money you borrowed is compounded, “that money is working against you at a much faster rate,” says Bibbo.

If you owed $1,000 on a credit card with an interest rate of 16%, simple interest would mean you would pay $1,160 over a year. But credit cards work with compound interest. So the same balance with compound interest requires you to pay $1,172 over one year. Over a five-year period, your simple interest payment would be $1,800, but compound interest would be $2,214. “It’s money working against you, money that can be used elsewhere,” Bibbo says. “As a borrower, not understanding compound interest can put you in a hole that can be hard to get out of.”

What should I do with this information?

Remember that compound interest is a great thing for investors, which should encourage you to invest as much as possible, so you can watch your money multiply over time.

And look for ways to lessen the negative effects of compound interest on your debt. Negotiating with your lender to lower your interest rate, pay more than the minimum, or better yet, pay your credit card bill in full each month are the best ways to do this.

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