One of the most useful concepts many need to learn about to be financially literate is compound interest. It is often explained as your money basically working overtime for you and snowballing.
But what does that mean? When you deposit money into a savings account, this initial amount is called the principal. You then earn interest on the principal. With regular or simple interest, the interest is calculated only on the principal, whereas compound interest is that interest is added to your initial amount, and future interest is calculated on the new, larger total. As time passes, this leads to a snowball effect. So compound interest is calculated on the principal plus any previously accumulated interest.
For example, if you invest $1,000 at a 5% annual interest, after one year you’ll have $1,050. By the 2nd year, you don’t just earn interest on the original $1,000—you earn it on $1,050. By the 10th year, your money grows to about $1,628.89 without you actually having to deposit a single extra dollar. That’s the unique part about compound interest.
Something to look out for is the compounding frequency—this is how often the interest is calculated and added to the principal. It could be annually, quarterly, or monthly. Naturally, the more frequently it compounds, the faster the money grows.
Of course, the higher the interest, the greater the growth. The frequency of compounding is also an important factor: interest compounded monthly grows faster than interest which is compounded annually.
The best piece of advice from people who know extensively about these accounts is that it’s important to start saving NOW, even if it’s a small amount, because this can snowball into a significant amount over decades.
By understanding and harnessing the power of compound interest, you can take another step towards your goals of long-term financial stability.
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