Although compound interest can make you money while you’re relaxing on the beach, many of us don’t put ourselves in positions to earn said compound interest. Sometimes that is simply because our financial education is not on point, or because we lack the resources. However, for a larger percentage of people, the concept of compound interest goes over their heads. How does it even work? Well, here is how.
Compound interest vs simple interest
Simple interest is typically paid out at the end of a specified term. That is usually, but not always, a one-year term. Simple interest is, well, pretty simple to understand. For example, if you put $10,000 into a savings account for a term of one year at a rate of 5 percent simple interest (you would be lucky to get that rate these days), at the end of the year you would have earned $500.00. So, you will end up with $10,500.00. A good example of an account with simple interest is a CD (Certificate of Deposit) in which you are promised a certain interest rate at the end of the specified term. By the way, simple interest usually works so that the longer the term, the higher the rate of interest.
But here’s where it gets exciting!
With compound interest, interest is paid, not only on the initial principal (that’s your $10,000 from the previous example), but also on any accumulated interest that you earn along the way. Interest is usually compounded at monthly intervals. It is double-dipping because you are earning interest on your interest. You are not doing any work, but your money is working hard for you. Hooray!
Because you are receiving interest on your principal plus your interest, compound interest is more difficult to calculate. But let’s give it a go:
If you invested $1,000 for one year at 5 percent, with interest calculated and added monthly, you would earn $1051.16 in compound interest after one year. Maybe that doesn’t sound like a huge difference, but if you left your money in savings for five years, then your returns with compound vs. simple interest would be very different. Take a look:
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With simple interest, at the end of the five years, you would have $12,500.Can I figure this out myself?Sure. Here’s the formula for figuring out simple interest. Go for it!
And, if you thought that was easy (wink, wink) here’s the compound interest formula: ·Where: A = the future value of the investment, including interest P = the principal investment amount (the initial deposit) r = the annual interest rate n = the number of times that interest is compounded per year t = the number of years the money is invested My point is “no,” or “why do so?” Sure you can figure this out yourself if you have a few days to spend on it, but by that time you might be unemployed with no money to spend. So. No. Just get some help. Luckily, you don’t have to do it yourself! There are plenty of online sites that let you plug in numbers and receive answers. Below are two! Now you don’t have to do it yourself! Hooray again! No. No, I cannot imagine. | |||||||||||||||||||||||||||||||
Takeaway
The idea of what you don’t know can’t hurt you may be true, but it is also true that what you don’t know can’t help you. Or, at least, that is true in the case of earning compound interest. Why not let your money work for you while you go out and drink too many mojitos? With compound interest, you’re free to do so. But, on second thought, drink responsibly — 10 drink max.
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