Compound interest can make you rich or it can make a bad financial situation disastrous. It all depends on which side of the paradox you land. It is a savvy investor’s best friend and an unconscientious borrower’s worse nightmare. Whether you are looking to invest or to use credit wisely, it is imperative that you understand how compound interest works.
Before we dive into the deep end, let’s discuss the concept of interest. When you borrow money or buy something with credit, you are charged interest. Interest is a small fee you pay for the convenience of paying later. When you invest money, you loan someone else—the bank, a business, etc.—money to operate and make money. They pay you interest for allowing them to use your money. Interest is a small percentage of the outstanding balance owed that is charged at a regular interval—usually annually.
Simple interest accrues yearly, monthly or daily, and only on the principal—or the balance of what’s owed or has been invested. Compound interest accrues yearly, monthly or daily, but it accrues on the principal and the interest that has already been applied. So, you are paying or earning interest on interest. This is what makes compound interest so powerful.
One of the worst kept and unappreciated secrets to wealth is the concept of investing and earning compound interest. According to a survey conducted by George Washington University, 66% of Americans don’t understand this concept. When you put money in an investment with compounding interest you make money just by allowing the money to sit. You earn interest on the original investment and on the interest it accrues. The more money you add, the faster it grows. You can literally earn money by sitting and doing nothing. Just invest and let it rest.
Of course, this is a simplified view of investing and a lot of other factors—especially risk—effect how fast your money grows. The greater the risk, the greater the reward or consequence. Before you invest, it’s important that you perform due diligent research and understand all of the intricacies—interest type and rate, type of investment, level of risk, penalties, fees, etc.—that can affect your bottom line. You want to find an investment strategy that suits your needs, circumstances and risk tolerance.
Ready to get on the right side of compound interest?