We are so used to thinking of interest as the bad guy. And for good reason.
Many of us are paying interest, and when it’s compounded, we are actually paying interest on our interest.
When in debt, this situation leads to a rather discouraging state of affairs in which it is difficult to get out from under the debt.
However, compound interest isn’t, itself, evil.
How Does Compound Interest Work?
With a traditional simple interest, interest is earned on the principal.
For example, if you had $1,000 and you earned (or paid) 3% a year, then every year, you would earn (or pay) $30. Regardless of how long you have the investment or loan, you’re going to pay the same amount every year, $30.
Compound interest, on the other hand, is very different.
Compound interest lets you earn interest on your interest.
If you take the same $1,000 investment, at the same 3% interest rate, then at the end of the year, you’ll have $1,030.
In the second year, you’re going to earn the same 3%, but now you’ll earn it on $1,030 instead of the original $1,000.
Now you’ll have $1,030.90.
Sure, it might not sound like a huge difference, but the longer the investment sits, the more that you’re going to earn.
Indeed, compound interest, like so many other things in life, is a tool. It all depends on how you use it. In the case of compound interest, it often depends on which side of compound interest you are on.
This infographic offers an interesting look at compound interest. (click on the graphic for enhanced details)
You know that interest is just money you pay directly into someone else’s pocket.
Interest is the fee you pay in order to be able to borrow money. Lenders want to be able to earn money off the money the provide you, and so charge interest. You aren’t receiving any goods or even any direct services when you pay interest.
When you are in debt, you can continue paying interest long after any enjoyment you derived from spending the money is gone.
As you can see from the infographic, there are some moral issues associated with charging excessive interest.
However, regardless of what has been written anciently, compound interest — and even usury — have become regular parts of our financial system. And regular parts of our lives.
The infographic also makes an interesting point about how often interest is compounded.
When interest is compounded, it is added to your balance. Then, the next time interest is charged, you are charged on your principal, plus the interest charges incurred the last time.
One of the reasons credit card debt is such a pain is that many cards compound interest daily. This means that your balance grows every single day, just from the interest.
The more often interest is compounded, the more the fees…well, compound, growing a little bit bigger each time.
Using Compound Interest in Your Favor
I especially like the Albert Einstein quote in the infographic.
Clearly, those who understand the true implications of compound interest are better off than those who don’t. The trick is to get compound interest to work in your favor.
While you probably wouldn’t charge interest to family and friends that borrow from you, chances are that you have other ways of earning compound interest. Many investments and cash products provide you with the opportunity to earn compound interest.
Regular contributions to accounts that provide you with the opportunity to earn interest can help you build up a nest egg, and prepare for the future.
While compound interest will work with one lump sum initially invested or deposited, you can build your wealth more effectively if you continue to add to your accounts.
Regular savings and investments can help the power of compound interest work even more in your favor. (Of course, with investments you have to be careful, since you can lose money as well.)
What Investments have Compound Interest?
It’s easy to see from the infographic that compound interest can be one of the most useful tools in your investment portfolio, but where can you find these type of interest? There are several investments that you can take advantage of that will allow you to make interest on your interest.
The most common type of account where you can earn compounding interest is a savings account. Just about every single bank in the America has a savings account that has compounding interest. Savings accounts aren’t going to have a high-interest rate, but it’s more than you’ll earn with your money in a checking account.
Another investment that earns are bonds. There are some bonds that you can purchase that pay fixed interest, but there are others that are going to pay compounded interest. Normally, any bond that pays compounded interest is going to be a zero coupon bond.
There is also a less traditional option to get compound interest, and it’s not technically compound interest, but it works just as well. If you have money in stocks, then you’ll get pay dividends on the amount that those stocks make.
Now, if you took the money that you earned on dividends and bought more stocks with that money, it’s going to work very similar to compound interest. Those stocks that you bought with the dividends will hopefully earn dividends as well, which you can use to purchase more stocks and so forth.
Getting Started Investing
One of the most important things is to start investing as soon as possible. Compound interest is an excellent technique to make the most of your money, and the soon that you invest, the more profitable it’s going to be.
If you’ve never invested before, it can be scary to get started, but it doesn’t have to be. Purchasing bounds with compound interest is very simple. In fact, bonds are one of the easiest investments that you’ll ever make.
Thanks to the Internet, it’s never been easier to start investing.
There are dozens of websites that will handle all of the investing for you. Sites like Betterment use algorithms and robo-advisors which will invest your contributions for you based on your financial goals.
Not only will they invest your deposits, but they will also invest the money that you make. Every time that your investments earn money, the robo-advisors will automatically reinvest that money, which is basically how compound interest works.
In the end, though, compound interest itself is not necessarily evil. At least, not when you’re on the receiving end.
One important thing to note is if you’re on the other end of compound interest. If you have a loan that is compounding every month or year, it’s important that you take out those loans as quickly as possible. Even a small loan can end up being a massive amount if you let it sit long enough.
If you have any questions about your investments or ways that you can make the most of your money, I would suggest that you make an appointment with a certified financial advisor. They can help you create a financial plan and help you reach your retirement goals.
The vast majority of Americans are not on track to reach the retirement that they want. Nobody wants to work until the day that they die, but if you make the proper investments, then you can live your retirement dreams.