WTFinance: What is Compound Interest?

It’s claimed Albert Einstein once said “the power of compound interest is the most powerful force in the universe.” While it’s still unknown if he actually said this or not, the message remains powerful and widely adopted and here’s why: Compound interest is basically interest on the principal amount + interest that has already accrued.

In other words, interest on interest. Here are the key factors to keep in mind:

• Principal = amount borrowed or invested
• Interest rates =
  • Interest paid on principal
  • Interest paid on accrued interest
• Compounding schedule = interest can accrue daily, monthly, yearly or any other schedule laid out in the agreement.

Depending on whether you’re earning compound interest by saving money, investing, or paying it off on credit cards, loans, etc., compound interest can either help you out or hold you back.

Working in Your Favor

Let’s say you deposit $1,000 into a savings account that pays 1% interest compounding annually. At the end of the first year, you would get $10 in interest, bringing the account balance to $1,010. Assuming you don’t make any deposits, at the end of the next year, you would earn 1% on the $1,010 in your account, earning $10.10 in interest at the 1% rate. At the end of the second year, your balance would be $1,020.10.

Though in this example the increase seems small, over time (and depending on the interest rate) you can see how the dollars can add up without much effort on your side. So take a look at the interest rate on the accounts you have now, and keep this in mind if you ever consider signing up with a new bank.

Considering the Downside

Now, say you have a $5,000 credit card balance on a card that has an annual percentage rate (APR) of 15%, which compounds daily with a 30-day billing cycle. First you should calculate your daily interest rate from your purchase APR by dividing the 15% purchase APR by the number of days in a year. Then you multiply the daily rate by your average daily balance. Next: multiply that number by the number of days in your billing cycle to get your monthly interest charge.

In this case, your monthly interest amount is $63.70. Meaning, if you were to make payments of $63.70 every month to pay off the compound interest (and without spending any more on that card) your balance would never go up or down. However, by only paying the interest rate, you’re not making progress towards reducing the overall amount you owe on the card balance.

In the end, you have to factor in the amount you need to pay for interest as well as an additional amount you want to pay to decrease your debt in order to work toward clearing the balance.

Now What?

Are you earning or paying compound interest? If you’re earning it, congrats – keep it up! If you’re paying it on credit cards, student loans, mortgages, etc. you can use an online calculator, like the Securities and Exchange Commission’s, to see how much you’ll end up paying – and can adjust your budget accordingly.