What Is Compound Interest?

ByAgkidzone Staff

Updated: Nov 15, 2024

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Compound interest is a powerful financial concept that can work in your favor when investing or against you when borrowing. It essentially means earning interest on both your initial investment and the interest that accumulates over time. Understanding compound interest can help you make smarter financial decisions, whether you’re investing for the future or managing debt.

What Is an Investment?

An investment is any action you take to grow your money. For example, keeping your money in a basic savings account is an investment, even though it might have a low-interest rate. These accounts are popular because they let you access your funds easily with few fees. However, if you want your money to work harder, consider high-interest savings accounts or term deposits. These options usually offer better returns, but withdrawing your money can be more challenging and may come with higher fees.

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Principal and Returns

Your principal is the original amount you put into an investment, while the money you earn from that investment is called your return. Banks pay you interest as a way to compensate for using your money. They lend this money to others, charging interest, which creates a cycle of lending and repayment. The key for investors is to find ways to maximize these returns while understanding how their principal is working for them.

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What Is Interest?

Interest is the money you earn on your savings or term deposits, expressed as a percentage. For example, if you invest $100 in a bank with a 10% interest rate for one year, you’ll earn $10 in interest, bringing your total to $110. If you keep that $100 invested for five years at the same rate, you’ll earn $10 each year, ending up with $150 after five years. This is an example of simple interest, where the interest is calculated only on the principal.

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What Is Compound Interest?

Compound interest takes it a step further. Instead of just earning interest on your principal, you also earn interest on the interest you’ve already made. Using the same example, if you reinvest the $10 interest back into your account at the end of the first year, your principal for the second year becomes $110. You’ll then earn $11 in interest for that year. Compound interest grows your money faster because you’re earning on both the principal and the accumulated interest.

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Compound Interest Calculation

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Compound Interest and Monthly Payments

The more frequently you earn interest, the faster your investment grows. If you save $100 monthly with a 10% interest rate and interest compounds monthly, you’ll earn about 83 cents in the first month. Adding this to your principal, you’ll have $100.83 for the second month, earning roughly 84 cents in interest, and so on. By the end of one year, your account could grow to around $110.47, showing how monthly compounding accelerates growth.

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Compound Interest and Debt

Compound interest doesn’t just apply to savings—it also impacts debt. Credit card balances, car loans, and mortgages can accrue compound interest, making the total debt grow over time if not paid promptly. To avoid letting debt snowball, make payments as soon as possible and try to defer interest charges when you can. For some loans, interest is charged on the original amount for the entire loan term, which means paying down the principal doesn’t reduce your interest payments. Be sure to read loan terms carefully to avoid surprises.

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Should I Pay Debts or Save Money?

It’s always smart to grow your savings and reduce your debt, but sometimes choosing between the two can be tough. Debt often comes with higher interest rates than what you earn from savings, so it usually makes more sense to pay off debts first. However, there are times when saving might be the better option—like when you need money set aside for future expenses. Putting funds in a savings account can earn you a bit of interest until you need them. Check the fees and rules for your accounts or speak to a financial advisor to help decide the best strategy for your situation.

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