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Compound interest explained

Compound interest explained
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Compound interest is a common term in the world of personal finance and investing. It’s an important concept to grasp because it can work in your favour or against you. I’m going to explain everything you need to know about calculating compound interest, why it’s important, and how it can help you.

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What is compound interest?

The most thorough way of explaining this term is that it is interest calculated on both a principal sum and accumulated interest from previous periods for either a loan or a deposit.

A simpler way to think of it is that any interest is added on top of the starting sum. So the next time interest is calculated, it’s on a larger sum. 

Sometimes this is referred to as interest earning interest.

This may not sound particularly important, but the compounding effect over time as interest accumulates can be quite astounding. That is why the effects of compound interest are sometimes even referred to as ‘magic’. 

Calculating compound interest

Although the effects may appear to be magical, I can assure you that calculating compound interest uses a simple mathematical formula.

If you love maths, you can find the full equation online. If you’re like me and want to keep things easy, you can use a compound interest calculator. There are plenty available on the internet. You just put in the required variables and they will then give you a breakdown displaying how interest can compound over time.

What types of accounts can benefit?

The two main types of accounts that can benefit from the effects of compound interest are investments accounts and savings accounts.

Investment accounts

The power of compound interest works best over a long period of time, and ideally with a high interest rate. For these reasons, you will often hear compound interest mentioned in relation to investing. It’s worth noting that you must be reinvesting any gains in order for compounding to work. 

Savings accounts

Although the interest rates on savings accounts may be lower than those on investment accounts, they can still benefit. It’s still important to ensure that any interest earned is left within the account.

How to make compound interest work for you

Imagine for a moment that your savings or investment account is a snowball. Every time it rolls over and more snow (interest) is added, it grows larger and attracts even more snow.

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Using compound interest to your advantage will accelerate the growth of your savings or investments and help you reach your financial goals faster.

The key factor that allows savings to flourish using this approach, is time. The longer you are able to leave the money in an account to grow and let the snowball roll, the greater the compounding effect will be. 

How compounding interest can work against you

The less exciting side of this concept is that it can really work against you in both investing and debt. 

When investing, compounding interest can also apply to any fees or costs associated with your account. Over time, these costs work out to be a lot more than what at first may have seemed like a small percentage.

This is because you are effectively losing out on all the potential compounding gains of those costs, eating away at your investments. That’s why it’s really important to use one of the best share dealing accounts with low fees or a top-rated stocks and shares ISA to help you minimise costs. 

The lesser known downside of compound interest applies to credit cards and loans. When you borrow money, there’s usually an agreed percentage of interest you pay back on top of the initial loan.

This means that your debts can also have a compounding effect over time. In order to prevent falling into this debt spiral, it’s really important to try and use a 0% credit card.

If you have existing credit card debt, it may be worth switching to a balance transfer credit card with a lower rate of interest.

Takeaway

Compound interest can be an extremely useful tool for building wealth, but it can also slow down your progress immensely.

To mitigate the negative effects:

  • Keep your fees as low as possible when investing
  • Strive for the lowest interest rate you can when borrowing

For building wealth, a higher rate of interest and a longer time period will allow you to reap the most reward.

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