Understanding the way compound interest works is key to building wealth or avoiding crushing debt. Here’s how to make it work for you

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Warren Buffet once famously said that his wealth came from “a combination of living in America, some lucky genes, and compound interest.” 

The billionaire investor meant that the interest his investments earned helped create his fortune. But Buffett also liked to warn people about the dangers of ending up on the wrong side of the compound interest equation.

While compound interest is arguably the most important component to wealth-building, it can also be one of the best ways to wreck your finances: Having to pay compound interest can cause debt to spiral out of control. 

Most people only think of interest in terms of how high or low a rate is. But understanding how interest is calculated, or compounds, is important too. Knowing how compound interest works can help you avoid expensive mistakes and make the most of your money, whether you’re depositing it, investing it, borrowing it, or spending it. 

What is compound interest?

All interest is a percentage charged on, or earned by, a lump sum of money. Compound interest is a kind of interest based on adding the original principal — that is, the initial amount invested or borrowed — with the accumulated interest from previous periods.

For example, say you have $100 in a savings account, and it earns interest at a 10% rate, compounded annually. At the end of the first year, you’d have $110 (100 in principal + 10 in interest). At the end of the second year, you’d have $121 (110 in principal + 11 in interest). At the end of the third year, you’d have $133.10 (121 in principal + 12.10 in interest). And so on.

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In other words, with compound interest, you earn interest on interest. 

The revelation comes when you realize that compounding interest makes the principal grow exponentially, meaning as interest accrues and the quantity of money increases, the rate of growth becomes faster.

How quickly your money grows depends on the interest rate, and the frequency of compounding. Interest can be compounded daily, monthly, quarterly, or annually, and the more frequently it’s compounded, the faster it accumulates. 

Over the long term, “the magic of compounding” can really add up. Here’s how an initial investment of $5,000 would grow if compounded semi-annually over a period of 35 years, at an annualized 5% interest rate:

If you’re the one earning money off the interest, daily or monthly compounding are preferable to yearly. On the other hand, if you’re being charged interest, monthly or yearly compounding will save you money compared to daily.

Compound interest vs. simple interest

While compound interest is “interest on interest” — calculated on both the principal amount and the accumulated interest — simple interest is wholly different. Simple interest is calculated only on the original principal balance or deposit.

Let’s take our $100 savings account again, only this time it’s paying 10% in simple interest. That means the 10% interest rate applies only to your original principal amount of $100, so you earn $10 each year. Period. At the end of the first year, you’d have $110. But …read more

Source:: Businessinsider – Finance


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