HOW COMPOUND INTEREST CAN BOOST YOUR SAVINGS — OR KEEP YOU IN DEBT

Without interest, your money doesn’t grow.

If you keep cash in a shoe box at home for a rainy day, your total won’t increase unless you add more to it.

That also means the 50 bucks you borrowed from your sister won’t go up to $75 when it’s time to pay her back next Friday.

But if you were to keep your savings in a bank account or take a loan from a payday lender, the outcome would be different. You’ll see an increase to your savings — or what you owe. 

That’s all due to compound interest — but what is it and how does compound interest work?

What Is Compound Interest?

Compound interest is a basic financial concept that explains how your money can grow exponentially. Your balance increases by earning interest on the interest.

A bit confusing, we know. So let’s break it down with an example.

If you had $1,000 in an account earning 5% interest on an annual basis, you’d end up with $1,050 at the end of the year. If your interest is compounded, you’d earn 5% of your $1,050 balance — an additional $52.50 — by the end of the second year, leaving you with a total of $1,102.50.

Simple interest, on the other hand, is when you earn interest on your original balance only. Your interest earnings aren’t factored in when it comes to calculating interest in subsequent years.If your $1,000 was in an account earning simple interest at the same 5% annual rate, you’d still have $1,050 at the end of the first year. However, at the end of year two, you’d only earn interest based on the $1,000 you initially put in there, not on the $1,050. You’d earn another $50 instead of $52.50, leaving you with a balance of $1,100.

Now, an extra $2.50 is far from a big deal, but let’s say you left that money in your account for 20 years instead of two. With compounding interest, you’d have $2,653.30 at the end of 20 years. Using simple interest, you’d only have $2,000.

How to Make the Most of Compound Interest

Understanding the different factors that affect your money’s growth can help you take advantage of the power of compound interest.

Don’t Stop Saving

It can be tempting to drop money into an interest-bearing account once and just let the magic of compound interest do its thing. But you’ll benefit more — a lot more — if you regularly add to your savings.Remember the $1,000 from the previous example that grew to $2,653.30 at the end of 20 years? Let’s say you had only half that much to start, but you committed to depositing $10 into your account every month. That money, earning interest on your $500 initial principal plus the $10 you put in month after month, for 20 years, would grow to $5,294.56. By making the $10 monthly deposits, you’ll have invested $2,900 of your own money over 20 years — and earned $2,394.56 in interest. When you initially save $1,000 and make no additional contributions, you only earn $1,653.30 in interest. So keep putting away money, even a little at a time.

Consider the Frequency

How often interest earnings are calculated also plays a big role in how much you can save.

Our earlier examples were based on interest that was compounded once a year. However, interest can be compounded at other regular frequencies, such as monthly or daily. 

Compounding frequency can also be discussed in terms of compounding periods. If interest is compounded monthly, you’d have 12 compounding periods in a year. If it’s compounded daily, you’d have 365 compounding periods in a year.

Using the same example of $1,000 in an account earning 5% interest, here’s what you’d end up with after 20 years at different compounding frequencies.

• Annually: $2,653.30
• Monthly: $2,712.64
• Daily: $2,718.10

The more often interest is compounded, the greater your savings will grow. 

And just because your bank only drops your interest earnings into your account once a month, doesn’t mean the interest is compounded monthly. Many financial institutions that compound interest on a daily basis wait until the end of your monthly statement period to tack on those earnings.

How Does Compound Interest Work to Your Disadvantage?

While compound interest can be a significant savings boost, it’s not all rainbows and roses. Compound interest is also the reason why you never seem to get your head above your credit card debt while making minimum payments. Just as your savings balance grows when interest is compounded, so does the balance of what you owe. When you make a credit card purchase or take out a personal loan, your lender will charge you interest, which is added to your balance. You’ll then be charged interest based on your new balance — the original amount plus the interest accrued (minus any payment you’ve made).Compound interest can really hurt you in the case of negative amortization. That’s when your monthly payment is less than the interest that accrues over that period, and your outstanding balance increases instead of going down. When you take out a loan or open a new credit card, here are four things to keep in mind:

1. Score the lowest interest rate you can. Increasing your credit score will usually result in lenders offering you lower interest rates.
2. Keep your lending period short. You’ll pay less interest with a three-year car loan than you will with a five-year loan.
3. Pay more than the minimum. If you dig through your credit card statements, you’ll see a section that details how long it’d take to pay off your balance if you only made minimum payments and how much you’d pay in interest compared to what it’d take to pay your balance off in three years and how much you’d save.
4. Make biweekly payments. You’ll end up putting more money toward your principal balance and pay less in interest by making payments on your debt every two weeks rather than once a month.

Not all lenders compound the interest they charge. Interest calculated for a mortgage loan, auto loan or federal student loan will usually be simple interest — interest based solely on your original loan amount.