What is Compound Interest?

Published by Thomas Herold in Accounting, Banking, Economics

'Compound Interest' is explained in detail and with examples in the Banking edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Compound interest represents interest which calculates on both the original principal amount as well as the interest that was accumulated previously during the loan or investment. Economists have called this miraculous phenomenon an interest on interest. It causes loans or invested deposits to increase at a significantly faster pace than only simple interest, the opposite of compound interest. Simple interest proves to be interest that calculates on just the principal amount of money.

Compound interest accrues at an interest rate which determines how often the compounding occurs. The higher the compound interest rate turns out to be, the faster the principal will compound and the more compounding periods will occur. Consider an example of how effective compounding truly is. $100 that is compounded at a rate of 10% per year will turn out to be less than $100 which is compounded at only 5% but semi annually during the same length of time.

Compound interest is important to individuals as it is able to take a few dollars worth of savings now and transform them into significant money throughout lifetimes. Investors do not need an MBA or a Wall Street background in order to benefit from this principle. Practically all investments earn compounding interest if the owners leave these earnings in the investment account over the long term.

This form of interest cuts both ways on the receiving and paying sides. When individuals are saving and investing money, it helps them grow the amount faster. When they are borrowing and paying the same interest on the debt, it grows against them faster. Individuals who are saving wish their money to compound as often as they can. Individuals who are borrowing wish it to compound as infrequently as possible. Savers are better off if they are able to compound quarterly instead of annually while just the opposite is true for borrowers.

For people who are compounding their investments, time works on their side. Money that grows at a rate of 6% each year doubles every 12 years. This means that it increases to four times as much as the original amount in only 24 years.  For individuals paying compound interest, time is similarly working against them. Credit card companies utilize this principle to keep their card owners in debt forever by encouraging them to only make minimum monthly payments on the bills.

Thanks to compounding, a smaller amount of money that a person adds to an account upfront is more valuable than a larger sum of money he or she adds decades later. This cuts both ways. By paying down principal on a credit card with an extra $5 per month, the amount of compound interest individuals pay on a 14% interest rate credit card decreases by $1,315 over ten years. This is true even though they have paid only $600 in extra payments over this amount of time.

Anyone can make the miracle of compounding work for them. The idea works the same whether individuals are investing $100 or $100 million instead. Millionaires have greater ranges of investment choices. Even relatively poor people can compound their interest to increase their original amount and double their money as often as possible.

Compounding interest means that participants have to give up using some dollars today in order to obtain a greater benefit from them in the future. The little money may be missed now, but the rewards for the more significant amounts in the future will more than make up for the little sacrifice the individual makes now. Financial planners have claimed that the difference between poverty and financial comfort in the future amounts to even a few dollars in savings each week invested now rather than later.

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The term 'Compound Interest' is included in the Banking edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.