What is compound interest and how is it calculated?
Compound interest is one of the most useful and useful tools when it comes to saving money. Whether someone is saving money for their rainy days or emergency fund, or taking the next step to set aside a portion of their salary for longer-term goals like retirement, the accumulation of interest reinforces this objective.
Saving as much money as possible and doing it when you’re younger makes it more efficient. This basic concept means that a person earns interest in addition to interest whether they have saved $ 500 or $ 5,000.
Many experts have touted compound interest as the biggest advantage investors have in accumulating more money for a down payment on your first home, vacation, or retirement. Giving up that dessert or that dear pair of headphones really adds up in the long run.
What is compound interest?
Compound interest is pretty straightforward – it’s when the money you’ve saved earns interest from a bank or credit union or a retirement account like a 401 (k) or IRA plan. It also works in reverse. The interest you earn by not paying off your credit card account or high-interest personal loan balance can add up quickly, making it harder to save.
Simply put, compound interest is simply interest on interest. The more money you can put in a savings account, CD, or retirement account, the more interest you can earn. Even if you can only save a small amount like $ 25 per week or $ 100 per month, the compound interest on that amount can add up quickly.
How to calculate compound interest
The formula for calculating the amount of compound interest that will cause your capital to become:
A = P (1 + r / n) (nt)
In this equation, P is the principal, r is the interest rate, n is the number of compounding periods in a year, and t is the duration in years. Using this equation, we can calculate A, that is, the final amount.
So let’s use an example. You deposit $ 15,000 into a savings account at an interest rate of 5% compounded monthly for 10 years. That would make r 0.05 and n 12. If we entered everything in the formula, it would be:
A = 15,000 (1 + 0.05 / 12) (12 * 10) = 15,000 (1 + 0.0041667) (120) = 15,000 (1.64700949769) = 24,705.1424654
In 15 years, your deposit of $ 15,000 will turn into approximately $ 24,705.14.
If you were just trying to figure out how much interest that would be without the principal, just do the formula, then subtract the principal. That would give us 24,705.142654 – 15,000 = 9,705.14246535. That would be about $ 9,705.14 in interest.
Impact of compound interest on savings accounts
Many people start saving money and earning interest on a basic savings account because there are no penalties for withdrawing money. Consumers can increase the amount of money they have saved and earn more interest when they automatically see their paycheck money going into a savings account.
When an individual does not withdraw money from their savings account, they can earn more interest. Simple interest is interest on principal only. If a person puts $ 100 into a savings account and earns 10% interest per year, the account will be worth $ 110 in one year. If that money stays invested and earns 10% interest for one more year, there will be $ 121 in the account – $ 10 simple interest each year and $ 1 interest the second year on the $ 10 earned in interest the first year. Adding more money in the second year will result in more savings as it will be added to the new balance.
How Compound Interest Helps Grow Retirement Accounts
The sooner employees can start saving money in a 401 (k), IRA, or Roth IRA plan, the more money they can accumulate due to compound interest. Investing in stocks through a mutual fund or an ETF can increase the amount of money in a retirement portfolio. Experts recommend that investors start saving for retirement even if the amounts are smaller at the start, say $ 200 per month, and have a diversified stock portfolio. As your salary increases each year, increase the amount you save for your retirement. Avoid spending bonuses and try to save that amount for your retirement as well.
It’s also important to watch the fees charged by a mutual fund, pension plan, or financial advisor, as fees also compound over time in the same way as investment returns. Even a seemingly harmless 1% fee adds up over 30 or 40 years.
For example, a person who puts money from their paycheck into a retirement account that grows 8% per year before fees and pays 1% of assets under management to have that account managed actually earns 7% compounded annually. . If the account had saved $ 1 million, in 20 years the amount would increase to $ 3.87 million. However, if the person did not have to pay 1% in fees each year, they would have accumulated $ 4.66 million for their retirement. While 1% doesn’t seem like a lot of money, in this scenario it means losing $ 790,000.
Many experts, such as college professors and financial advisers, recommend that people start saving as soon as possible. The more money you save, the more money you can make with interest alone.
Even during volatile times in the stock market, the more money a person accumulates in a retirement account, the more money is accumulated.
When compound interest hurts consumers
On the other hand, accumulating too much interest is detrimental to an individual. Interest calculated by credit card companies, payday lenders, or other lenders who offer auto loans or mortgages can add up quickly.
Consumers who only make minimum payments for their monthly credit card payments often only pay interest because a small portion of their payment goes towards the principal amount or the amount of money borrowed.
Since many credit card companies charge double-digit interest rates, paying more than the minimum amount will reduce the amount owed much faster. When you increase a monthly payment by an additional $ 50 or $ 100, that means more money is paid each month towards the original amount of money that was borrowed and less on the interest.
As interest rates continue to rise due to decisions made by the Federal Reserve, people who continue to have a balance on their credit cards will end up paying more money in interest. Since credit card interest rates are adjustable, which means they can go up at any time, when the Fed raises the federal funds rate, they go up too. If you have high interest rates from your credit card company or other loan, making additional payments will help reduce the balance sooner. Refinancing a loan or mortgage is also an option and helps reduce the amount of interest you pay each month.
Once you’ve paid off the credit card payment, you can start taking the same $ 200 you paid each month for the bill and allocating it to a CD or money market account to save in case of emergency in order to avoid paying high interest rates.