What is compound interest?
Select’s editorial team works independently to review financial products and write articles that our readers will find useful. We may receive a commission when you click on product links from our affiliate partners.
The Chase FreedomÂ® is currently not available to new cardholders. Please see our list of best refund cards for alternative options.
Editor’s Note: The APYs listed in this article are current at the time of publication. They can fluctuate (up or down) based on changes in the Fed’s rate. Select will be updated as changes are made public.
Compound interest is a term you’ve probably heard of, but understanding how it works can save you in the long run.
A to study who reviewed information from S & P’s Global Financial Literacy Survey found that “Consumers who do not understand the concept of interest mix spend more on transaction fees, incur higher debt and incur higher interest rates. ‘higher interest on loans‘.
Whether you regularly use a credit card or save money in a high yield savings account, it’s important to note that interest is compounded, which means what you owe or earn may be. accumulate quickly.
Below, CNBC Select breaks down the difference between simple interest and compound interest, how the latter works, and the ways you can benefit from understanding compound interest.
Simple interest vs compound interest
Simple interest is calculated based on the original amount you borrowed or what you have in the bank. This is called your “principal”. Simple interest charges a fixed rate, which means that the interest stays the same for the life of the loan or account.
Compound interest, however, is calculated on your principal plus your accrued interest. This rate is variable and can change at any time. It basically pays interest in addition to interest.
Compound interest can work against you or in your favor, depending on whether you are borrowing or saving money. Below, we take a look at how much you could end up paying and earning with compound interest.
Let’s take a look at a hypothetical example of how compound interest can work against you.
Using time frames of 5, 10 and 15 years, we can see the effect of an interest rate of 16.61% (the average APR of credit cards by the The most recent data from the Federal Reserve) on a credit card balance of $ 6,194 (average American credit card debt). We have assumed that you only make the minimum payment.
As you can see in the table above, compound interest alone turns out to be quite expensive over time, so much so that it exceeds your initial balance after 10 years.
How Compound Interest Works in a Savings Account
If you put even a small amount of money into a savings account, compound interest can do the job for you and make your money grow exponentially faster than it would with interest. simple.
People often refer to compound interest as âmaking money for the sake of making moneyâ. To see how compound interest can make you money, let’s take the hypothetical example of depositing that same $ 6,194 into a high-yield savings account. We will use 1.21% as the interest rate, which is the current APY for the Vio Bank High Yield Online Savings Account and Varo Savings Account.
For this example, we’re assuming that you don’t make any monthly contributions or withdrawals and that interest is compounded daily.
Compound interest can make your savings grow faster. While you earn around $ 374.74 every five years with simple interest, you will earn interest on the new balance (principal + interest) when you have a compound interest account.
It is important to note the frequency of the composition because it can vary. Your interest can be compounded daily, monthly, quarterly, semi-annually or annually. The more frequent the funding periods, the higher the interest amount and the faster your money will grow.
Before opening a new credit card or savings account, be aware of the impact of compound interest on your debt or savings. Using the examples above, on the one hand, you pay $ 10,657 in interest only after 15 years, but if you put that same amount into a high yield savings account, you could earn 1,232.67 $ interest at the same time.
Information about the Wells Fargo Cash Wise VisaÂ® card, Capital OneÂ® SavorOneÂ® Cash Rewards credit card, and Chase FreedomÂ® was independently collected by Select and has not been reviewed or provided by the card issuer prior to their publication.
Editorial note: Any opinions, analysis, criticism or recommendations expressed in this article are the sole responsibility of the editorial staff of Select and have not been reviewed, endorsed or otherwise approved by any third party.