Albert Einstein once said: “compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it”. However, do you know how compound interest works on the money invested? It can increase the original amount you got or the debt you owe.
Knowing that this type of interest can positively or negatively affect your finances, it is important to understand how compound interest works and check some real life examples. Keep reading to learn all about it!
What is compound interest?
An easy example to explain “what is compound interest?” is to think about a snowball rolling down a hill. As long as it rolls, it gets bigger, accumulates more snow, and rolls faster. The same happens with this type of interest when it comes to money and investing.
If you invest money, you can earn interest, and that interest is reinvested to earn more interest. This is how the investment will grow exponentially, also called interest on interest. Because of that growth, Warren Buffett, a famous investor, said that compound interest is one of the elements that helped him build his wealth.
Buffet is the one that compared it with a snowball. As an expert, he said that compound interest is an investor’s best friend, so you must start building the snowball early. Investing early is a way to keep a long hill with a good financial return.
The investor is right about the period you count on compound interest because the longer one interest is applied to another, the return achieved will be higher. You just need to be careful if it is related to a debt, not an investment. In that case, the debt will also enlarge quickly, and it will be harder to quit the total.
How does compound interest work?
Now that you know the compound interest meaning, it is time to figure out how compound interest works. A practical example is: if you invest $100 and have 10% as an annual return, you will have $10 after one year. Then you will reinvest the amount in the same deal and, after another year, it won’t be just 10%, but 10% on $110, with $11 in return.
This is how the amount can increase year after year just by interest because it is reinvested to grow again. However, if you don’t invest in the same deal, it will become a different investment that can evolve the same way. You just need to keep it for as many years as you can.
Compound interest is the element that makes the earnings faster and increases not just the original value of the investment, but the chances of making more money. The majority usually continue the cycle, but others prefer to save it and use it for personal finances.
Compound interest works negatively when it is related to debts. When you have installments with this interest, it will grow over time. It may be better if you finish the payment as fast as you can in order to avoid increasing interest and difficulty in paying it.
How to calculate compound interest
Another common question is “what is the formula for compound interest?”, something not that easy compared to the meaning of the term. It is recommended to use a specific calculator. With this help, you have an automatic account according to the compound frequency (daily or annually). The results show daily interest, how much you will earn, and the annual percentage, also known as APY.
If you want to do it by yourself, it is best to follow a tutorial on YouTube. In case you put a different formula in Microsoft Excel, it can become an error that will make the worksheet filling difficult or give the wrong result.
Besides the main question “how compound interest works?”, another important thing is how the rule of 72 impacts the return. This rule estimates when the investment will double. It is easy to calculate. You just have to divide the number 72 by the interest rate (the percentage rate of return) to discover the years it will take to double the principal amount.
An example can be an investment with 6% as the rate of return. When divided by 72, the number 12 indicates the period when the amount will double, being a lot more than expected annually. This is why many investors say it can be easy to become wealthy.
Pros and cons of compound interest
If you understand how compound interest works, it is easier to see the benefits. For investments, the main advantage is the increasing value of the annual interest, which can be reinvested to earn more money every year, having the chance to double it.
The con is that, for debts, the snowball effect is not helpful. On the contrary, it is what makes a debt difficult to be paid. This is why you must be careful in which amount the interest is applied.
Know other financial terms at OneBlinc!
If you understand how compound interest works, you can use it in your favor and earn a lot of money. To learn more financial terms, keep reading the articles at OneBlinc, where you find all the financial help you need!
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