What is compound interest? Know the facts before you save or charge

If you have a savings account, you know what interest is. It’s that little bit of extra cash that the bank pays you to keep your money (and these days, unfortunately, it’s usually a very small bit).

You also know what the interest is if you have a credit card balance or loan. In that case, this is the fee you pay to borrow the money.

But interest is often supercharged—it’s just over one percent of your principal balance. it is called Compound Interest,

Compound interest is great news if you’re saving money — it can help your balance grow faster. But, that’s not great news if you’re in debt – it could increase your dues.

So it is important to understand compound interest before deciding where and how to save or borrow money. You should pay attention to how often the interest is compounded. And you should avoid letting your credit card balance grow.

simple vs compound

To understand how compound interest works, let’s look at another type of interest: simple interest.

Let’s say you invest $1,000 at 5% annual interest, and then you don’t touch that money. At the end of 10 years, you’ll have $1,500—your principal investment plus $50 in interest each year for 10 years. After 20 years, you’ll have $2,000. After 30 years, you’ll have $2,500. That is simple interest. Interest is charged only on your principal balance, even if you earn interest each year.

Now, let’s say you invest the same $1,000 at 5% per annum in an account that has compounded annual interest. After 10 years, you’ll have $1,629. 20 years later: $2,653. 30 years later: $4,322.

This is what financial professionals sometimes call “the magic of compound interest.” By age 30, if you had invested in a simple-interest account, you would have become richer by $1,822.

Why? Because compound interest means you are earning interest on interest. Each time you earn interest, it is added to your investment balance, and future interest is based on that increasing amount.

Now suppose your interest is compounded monthly instead of annually. Instead of $4,322, you would have $4,468 after 30 years. And if your interest is compounded daily, you’ll have $4,481.

The more interest is added to your balance, the faster your money grows.

(There are tools online to help you calculate how much you can earn from compound-interest investing using various variables, such as from this one US Securities and Exchange Commission,

Compare Accounts

These days, most bank savings accounts offer compound interest. Yes, their interest rates are generally surprisingly low – only 0.07% on average for a $2,500 deposit until May 16 – But your money will grow faster because the interest is compounded over and over again.

You will do better with a certificate of deposit, depending on how long the tenure is and how much you invest.

Check the details before choosing which account to open. Find out what the compounding frequency is – how often is the interest compounded? The more times, the better. Also, banks may offer different interest rates depending on how much you invest. Find out if there is a minimum investment requirement.

You can compare compound-interest-paying accounts by checking each account. annual percentage yield (or APY), which are factors of compounding.

don’t be unbalanced

Unfortunately, when you use a credit card or take out certain loans, compound interest works the other way as well, making your debt more expensive.

Credit card interest rates tend to be fairly quick to begin with. The annual rate was about 16.2% on average as of February 2022, according to the Federal Reserve, But beyond that, interest is usually compounded daily based on your average daily balance for a given monthly billing cycle. That interest is continuously being added back to your card balance.

The good news is that you don’t have to pay any interest charges if you pay off your credit card balance every month when your statement arrives. But if you can’t zero out your balance, pay off as early as possible in your billing cycle. This will reduce the average daily balance on your card for the month, thereby lowering your interest tab. (Many credit card companies let you pay online before the bill arrives, even several times a month.)

power to pay principal

Most home mortgages and car loans are simple-interest forms of loans, but because of the way they’re structured, they seem like compound interest. At the beginning of the loan, most of your monthly payment goes toward interest, and less goes toward paying off your loan principal.

The repayment structure — called an . is referred to as redemption Schedule , If you pay off the principal earlier, especially on a 30-year mortgage, it costs you more in interest. This is because your balance remains high for years. So, consider making extra payments toward your mortgage principal. That way, you can pay off your loan early and save thousands of dollars in interest.

However, you should check with your lender about any prepayment charges associated with your mortgage. Also, make sure that your extra payment only goes towards the principal, not the interest.

Whether you’re looking at compound interest for your savings or loans, knowing what it means is the first step!

Finance FYI is offered by First Security Bank,

Feather Washington’s First Security BankWe take a customized and personalized approach to your financial wellbeing. We live in the communities we serve, so our branches offer solutions tailored to their communities. We believe relationships make a difference, and this is what sets Safety First Bank apart.

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