A serious interest: its work in wealth creation | Job Binary

When you put funds into a savings account or certificate of deposit, you earn interest that helps your money in the account grow over time. On the other hand, when you have a credit card or other type of loan, you can see how it affects you if you carry a balance or don’t make your payments on time.

It’s important to understand how compound interest works and how it affects your overall wealth—for better or worse.

What is compound interest?

Compound interest is the interest earned on the initial deposit you made into the account and the interest the account has already accumulated, also known as “interest on interest.” How often interest compounds occur depends on the frequency cycle, which can be daily, monthly or yearly.

Generally, the more often the account is added, the more interest is charged. For example, if you have $3,000 in principal in a savings account that earns 2% interest annually, your account will grow to $6,625 at the end of 40 years. But if your account adds interest every month, all the same, you’ll have $6,673.

Not only does compound interest grow your savings at a faster rate than simple interest, but it also requires a lower initial principal balance to reach those target balances. But it’s important to note that it may take some time to see a significant difference in your account balance (even with a faster compounding schedule), so start saving as soon as possible after you’ve got your financial goal.

Earlier we saw the example of a savings account that earns interest. But there are other types of accounts that benefit from earning interest on interest.

Savings accounts: Savings accounts are a type of bank account that earns interest on the money held. Funds in a savings account at a bank or other financial institution may compound interest on a daily, monthly, or annual schedule. Funds are readily available through bank transfers, withdrawals, and sometimes checks.

Certificates of Deposit (CD): a CD is a type of savings account that earns interest over a fixed period of time. Typically, a CD offers a higher rate of return than a traditional savings or checking account, but there is a condition that the funds remain untouched for this period of time, known as term. These terms range from three months to several years and earn interest daily or monthly when the investment compounds are held in a CD. If you choose to withdraw your funds before the end of the term, you may be charged an early withdrawal fee and miss out on potential interest.

Student loans: Compound interest does not always benefit the customer; it works against you when you get credit or credit cards. This includes student loans. While all federal student loans charge simple interest, some private loan issuers charge interest that is compounded annually, monthly, or even daily. This is often referred to as interest capitalization, where the total amount of accrued interest is added to the loan balance and interest begins to accrue. This can happen after the grace period ends, such as when a student graduates, and can be detrimental to borrowers who are making on-time payments at almost full interest and are having trouble paying principal.

Credit cards: Like student loans, credit cards add interest to your debt balance daily, monthly or annually, making it difficult to stay ahead of your payments. If you don’t pay off your credit card and are charged interest on your purchases, you can quickly fall into the trap of paying exorbitant prices for everyday purchases like groceries, says Kenneth J. Dean, Certified Financial Planner and Senior Director of Finance. Planning at Winthrop Wealth, a wealth advisory firm dedicated to maximizing the impact of its client’s wealth.

How does compound interest work?

Although compound interest looks complicated, it has the same components as simple interest, plus a few extra parts.

Basic balance to start: Initial value of funds in the account. For example, a $20,000 student loan would have a principal balance of $20,000. On the other hand, a savings account can have a principal balance such as a $100 initial deposit.

Interest: A small percentage of the amount of principal and previously received interest. Interest expressed as interest is the amount charged to the account holder for borrowing money or received as income by the account holder. When you invest, you want a higher interest rate because the higher the rate, the less time it takes for the investment to double, Dean says. But if you’re taking out a loan or using a credit card, you need a lower interest rate to extend the time it takes to double your debt.

Deposit and withdraw: Funds entering or leaving an account can affect how much interest the account earns. If you’re paying off a student loan, for example, you’ll reduce the principal and accrued interest, which in turn lowers the interest that accrues on the loan. But if you have a savings account, you make deposits to increase the balance that earns interest, thereby increasing the total interest earned in the account.

Connection frequency: How often account compounds can affect the interest you earn — the more often the interest compounds, the more interest you earn. Typically, accounts are consolidated on a daily, monthly, or annual schedule, but they may be consolidated on a quarterly or semi-annual basis. If you have a credit card that adds interest daily, it will take you longer to pay off the balance than if it’s compounded annually or even monthly, Dean says.

Duration: In addition to how often the account earns interest, another time factor is how long your savings should last. If you have a savings account that accumulates annually, but you withdraw the money before the end of the year, you won’t be able to add your money. Instead, “you want the investment to compound more often because the value eventually adds up to a bigger number,” says Dean.

How is it calculated?

If you want to know how soon you will need to increase your investment, you may want to calculate how much compound interest your funds will earn. Knowing how compound interest is calculated can help you understand what factors you can manage to achieve your financial goals.

For example, let’s say you need to save $15,000 over five years to pay for your wedding. Because you can’t adjust the length of the compounding interest rate, you may want to find a savings account with a higher interest rate, such as a high-yield savings account.

Sometimes you can adjust the length of additional savings periods, but you don’t have the power to change how much interest your account earns. No matter what your financial goals are, learning to harness the power of the compound interest formula can help you create a savings plan. Here is the formula:

A = P (1 + [r / n])(n)

A: The future value of an investment or loan, including accrued interest
P: The principal balance of an investment or loan
R: Annual interest rate expressed with decimal point.
N: Number of percentage compounds per year
T: Time in years the balance is invested or borrowed

Suppose you invest $1,000 in a 10-year CD that earns 5% compounded monthly.

In this example, we solve for the amount the account will accumulate over time, which is A. We know P = $1,000; t = 10; r = 0.05; and n = 12. So let’s plug these numbers into our formula.

A = $1000 (1+ [0.05 / 12])(12 * 10)
A = $1000 (1+ [0.05 / 12])(120)
A = $1000 (1+ [0.00417])(120)
A = $1,000 (1.00417)(120)
A = $1000 (1.6477)
A = $1,647.67

At the end of 10 years, a $1,000 initial deposit earns $647.67 in interest, with $1,647.67 in savings.

Simple interest and compound interest

If you have a car loan, you may be charged simple interest. This is a good thing because simple interest is calculated based on the principal balance. This means your lender won’t be able to charge you interest on any of the interest you’ve previously accrued over the life of the loan, saving you money.

But if you’re saving for a long-term goal, like retirement, you’ll want to look for an account that earns compound interest and earns interest on the total account balance, including interest earned. This will bring you high returns and will benefit you in the long run.

Take away

Understanding how compound interest works can help you make informed decisions about your investments and loans. If your goal is to pay off debt, the interest rate can really burn you if you let it build up without taking action, and it can quickly destroy any kind of wealth you’re trying to build in your life.

On the other hand, if your investment earns interest, the power of compounding is working for you. You can take advantage of this by starting to save as early as possible, giving your account more time to grow your wealth.

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