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Are you using compound interest to your advantage?

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compound interest

Perhaps the simplest way to earn a profit on your cash is through an interest-bearing investment. The ability to earn an interest is a key incentive that banks employ to motivate customers to keep their money in savings accounts. These types of accounts also allow passive investors to take advantage of the powerful force of compound interest. 

What is compound interest?

Compound interest is a way to calculate interest that allows you to grow your money faster by adding the interest returns you’ve already earned over time to the original principal every period. Earning “interest on interest” in this manner allows you to build more momentum than simple interest the larger your balance is and the longer that it’s invested.

Read also: How do interest rates work on your savings account

In more mathematical terms, compound interest can be calculated by multiplying the initial principal by the interest rate plus one, raised to the number of compounding periods. That will give you the total balance amount, so simply subtract the original principal from that result to come up with the total compounded interest earned.

That formula would look something like this:

Compound Interest = [P (1 + i)ⁿ] – P

Where P is the principal, i is the interest rate, and n is the number of compounding periods.

How does compound interest work?

The actual amount of returns would depend on both the interest rate and the frequency of compounding. These factors come into play in an interesting manner, and should be considered in parallel when evaluating investment options.

For example, a 10% interest rate may seem more attractive than a 5% interest rate, but the higher rate compounded semi-annually would actually earn less in a year if the lower rate is compounded quarterly.

This is illustrated in the table below, assuming an original investment of $100:

10% interest (compounded semi-annually)

PeriodBeginning principalEnding balanceTotal earnings
1100.00110.00  10.00
2110.00121.00  21.00

5% interest (compounded quarterly)

PeriodBeginning principalEnding balanceTotal earnings
1100.00105.00    5.00
2105.00110.25  10.25
3110.25115.76  15.76
4115.76121.55  21.55

Tips to maximize the power of compound interest

Here are some additional tips:

Invest early and often

The longer an investment is allowed to earn interest, the faster and larger it could potentially grow. This means you could also try to make it a point to continue investing more into your accounts whenever your budget allows.

An extra $100 or so added to your total investment each month, coupled with compound interest, can really supercharge your earnings over time.

Favor shorter compounding periods

We’ve shown above that the frequency of interest payouts can make a big difference in how much you can actually earn over the same time period. Savings accounts, for example, can compound interest on a daily, weekly, or monthly basis, so check this against the available rates to be able to choose an investments that suits your transaction and investment goals.

Compound interest on loans and credit

Compound interest is not only applied to investments, but also to other financial concepts, such as loans and credit lines, with which it might actually work against you. Obviously, this turns the tables around a bit, and means you would instead favor lower interest rates, shorter terms, and less frequent compounding periods. 

Some debts, such as those associated with credit cards, are compounded every month. Debts that are subject to compound interest can therefore get out of hand very quickly.

While the use of credit cards or loans sometimes can’t be avoided, but here are a couple of tips to help you manage these financial obligations:

Pay more than the minimum dues

Just as you might continue to add more money into savings accounts whenever possible, it can be a good idea to pay more than the minimum amounts due on your debts (but only when circumstances allow it).

An extra 5-20 dollars paid toward you debts every period can go a long way in paying them off significantly earlier, potentially saving you thousands of dollars in interest.

Keep interest rates low

The rates applied to debts and loans can greatly affect how quickly these obligations grow and how long it will take to eventually pay them off. If you’re balancing several debts (such as student loans), private lenders may offer attractive consolidation packages or refinancing options that allow you to focus on one larger (and less expensive) loan instead of several smaller loans. 

Compound interest and the Rule of 72

The Rule of 72 is basically an easy way to mentally estimate the time in years that it will take for an investment to double in value given an annual interest rate. This is done by simply dividing 72 by the interest rate (in percentage):

72 / (interest rate) = (years to double the principal)

Using this equation, we can, for example, determine that an investment with an annual interest rate of 6% will take around 12 years to double (72/6=12). 

While the Rule of 72 may not exactly be precise, the results are often close enough to let you make reasonably-informed financial decisions. Plus, the formula can also be applied to other situations, such as calculating how many years a debt would double in value, or how long inflation would halve the value of an investment.

The Rule of 72 is discussed in much more detail in another FlexAcademy article, but is also worth mentioning in any discussion on compound interest. 

Conclusion

“My wealth has come from a combination of living in America, some lucky genes, and compound interest.”

That quote above was written by Warren Buffet, one of the world’s most successful investors, and touches upon the importance of compound interest in generating (and protecting) wealth.

However, you should also be mindful of how the “snowballing” effect of compounding interest can also swing around to detrimentally affect your debts and other financial liabilities. Hopefully, the tips we’ve provided here can help you both grow your money and shield you from negative shocks.

All that said, smart investors also know not to rely solely on compound interest to meet their investment goals. For example, savings accounts carry little risk, but also yield much lower returns compared to other potentially higher-yield (and higher-risk) investments.

If you would like to learn more about alternative ways to make your money work, such as investing in stock markets, Academy has many more articles and resources to allow you to customize your portfolio to your specific needs.

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