Compound interest is one of the most powerful financial forces around. Understanding its power to boost your earnings, as well as its ability to work against you, is crucial.
Compound interest happens when your interest starts earning interest. Say your savings account earns $100 interest per year. That interest is added to the balance of your account at the end of each month, therefore increasing the balance of your savings account and increasing the amount of interest you’ll earn during the next month.
This is the same thing that happens with your debt, which is why your credit card balances get bigger if you don’t pay your cards off every month.
The compounding period is the length of time between interest additions. The interest rate, the compounding period, and the balance in the account determine how much interest is added.
Do the math
The mathematical formula for calculating the amount of compound interest is:
Interest rate (r) X Principle (P) or balance = the interest to be added
For example, let’s say your savings account had a $10,000 balance. Assume an interest rate of 5 percent was applied to that $10,000 balance. You would end up earning $500 in interest. You could apply the same equation to your debt, too.
How many years?
Now, the “Rule of 72” helps you calculate the number of years before your money doubles in investment or in debt. Simply divide the number 72 by the percentage rate you’re earning on your investment or paying on your debt.
If you borrowed $10,000 at 8 percent interest, 72 divided by 8 is 9. That means your $10,000 in debt would double to $20,000 in nine years if you never made any payments.
Now, say you invested $10,000 at 8 percent interest. You also could make $20,000 in nine years.
Start ‘em young
The more frequently your money compounds, the more money you’ll earn. That’s why it’s important to begin saving and investing regularly at a young age.
©American Institute of Certified Public Accountants