Understand the Power of Compound Interest
What is Compound Interest?
Compound interest is a powerful thing. Simply put, compound interest is interest
earned on interest. As an investment earns interest that interest becomes a part
of the original investment which in turn earns more interest. The interest continues
to accumulate on the principal, all past interest, and all subsequent interest until
the investment is withdrawn, hence the "compounding effect". This is opposed to
simple interest which is just interest that is earned on the original investment,
otherwise known as the principal.
The Ins and Outs of Compound Interest
Two important factors to consider when thinking about compound interest is the interest
rate for the investment and the frequency with which the money is compounded. Money
can be compounded yearly, monthly, weekly, or even daily. The more times that an
investment is compounded, the more interest the investment will earn with each subsequent
compounding. It is common for interest rates to be quoted on a yearly basis regardless
of the frequency of compounding. The annual percentage rate or APR is the most often
quoted figure and represents the interest rate over the course of one year.
An Example of Compound Interest vs. Simple Interest
Let's say two different people invest $1000 with an APR of 5%. Investment A will
be in an investment earning simple interest and Investment B will be compounded
annually. After the first year they both would have $1050. After the second year,
Investment A would be worth $1100 while Investment B, which is compounded annuall,y
would be worth $1102.50.
It doesn't seem like much does it? Let's see what the difference is after 30 years.
If you invest $1000 at 5% simple interest over 30 years you would have $2500. However,
if you had invested that same $1000 at a 5% APR that was compounded annually you
would have $ 4,321.94! That's over 70% more!
Try it Yourself!
The best way to get a feel for this is to try out some different scenarios on a
compound interest calculator. Go ahead and vary the different parameters in the
calculator and see how your investment would grow based on the assumptions you choose.
It really is amazing how even a 1% difference in the APR over time with compound
interest can add up to a lot of money.