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Compound interest is what makes saving and investing for the future possible. Without compound interest, it wouldn’t be realistic to save and invest enough to beat inflation.
Use this compound interest calculator to see the impact of compound interest over time:
What is Compound Interest?
Here’s how it works. Compound interest is when the interest you earn on an investment or savings vehicle starts to earn its own interest. For example, let’s say you invest $100 in an account earning 10%. In a year, you have $110.
Next year, you’ll earn 10% interest on that $110. That gives you $11 in interest for a total of $121. Remember, you only contributed $100. But now the initial $10 in interest helped you earn more interest the next year.
This is the beauty of compound interest. You can make a one-time contribution and see interest accrue over years and years. Even someone who saves $50 once will see a huge change after 50 years’ of compound interest.
The best way to take advantage of compound interest is to start saving as soon as possible. Compound interest rewards people who save anything, no matter what it is. Because of compound interest, it’s better to save a little now than to wait five years until you can save more.
What Makes Compound Interest Powerful
Time is the secret ingredient to compound interest, not how much you contribute or the interest rate. It’s better to save anything now than to wait until you feel like your contributions are more substantial.
However, if you can keep saving and adding every year, you’ll see even bigger gains. Increasing how much you earn also matters. An account that earns 2% is great, but an account that earns 7% is better.
Compound interest rewards people who build a savings habit and keep adding to it. It’s fine to start off by saving $25 a month, but it’s even better to increase that as you get older and earn more money. Think of compound interest like a snowball. You just need a small push to get it going. But as the snowball accelerates, it becomes more powerful.
How Compound Interest Can Hurt You
Compound interest is a blessing when you’re saving, but it can hurt you when you’re paying off debt. If you have a credit card with a $500 balance and 20% APR, you’ll see interest accrue quickly if you only make the minimum $25 payment. In this case, compound interest will grow unless you pay off the debt in full. This can be even more prevalent with payday loans and other high-interest loans.
It’s not just important to know how much you’re spending each month on a loan. You have to know how much interest is affecting the total payoff. You have to understand how debt can pile on and on if you’re not paying the loan off as quickly as you’re adding to it.
Compound interest can also hurt when you’re investing somewhere with high fees. These fees will cut into your compound interest and affect your total growth.