TAKING A GLANCE AT HOW COMPOUND INTEREST WORKS: Your Guide To A More Confident Financial Decisions

During childhood, we used to keep a portion of our school allowance either inside a piggy bank, somewhere inside our closet, or anywhere we think is concealed and is discreetly exclusive only to us. Thinking of it, sure, gives us a lot of nostalgia. However, doing the same thing now as an adult could put you at a disadvantage, for you are missing the perks when you should have put your money in the bank instead of just keeping it inside a piggy bank, your closet, and so on. These perks include: being safe from potential theft, money unharmed from insects and pests, and more importantly, the interest it might earn monthly, annually, depends on the bank.

In this article, a certain interest classification will be discussed, the commonly named compound interest. Interestingly, it offers much more gain than just merely simple interest. This will help you choose the banking institution, the right kind of bank account, more so, confident financial decisions.

 

WHAT IS COMPOUND INTEREST?

Compound interest or the so-called compounding interest is the kind of interest assessed on a loan or deposit premised on the initial principal as well as the accrued interest from preceding transactions. To simply put it, when an interest earns interest, it is then a compound interest.

Try to imagine it just like a snowball. The earlier you begin saving and the more money you add to your snowball, the larger it will grow. Consider what would happen if you have pushed the snowball off of a snow-covered cliff side. The snow you've already loaded would therefore remain, and you'll subsequently pile up even more. Once your snowball reaches the ground of the cliffside, it will have the snow you started in earnest together with, the snow it collected along the way, and much more snow on the pinnacle of that. That's simply how compound interest works. Thus, the more regularly you save and the greater the actual amount you spare, the higher the interest rate you will receive.

 

HOW DOES IT WORK?

At this point, let's try to compute the compounding of actual money that one might deposit.

Assume you have $10,000 in your bank account earning 3% interest per year. For the first year, you would earn $300, resulting in the latest balance of $10,300. Without touching your balance on your bank account, in the second year, you would therefore earn 3% on the larger balance of $10,300, which is $309, for a total of $10,609 at the close of the year.

Have you seen it? Without doing anything and just leaving your money for two years in the bank, you earned more than six hundred bucks through compound interest. Your savings account balance would sprout faster over some time as you earned interest on larger and larger balances. Now, suppose you placed $10,000 in this notional bank account for thirty years, earning a 3 percent annual rate of return the entire time and never added another chunk of money. In that case, you'd eventually wind up with a whopping balance of $24,272.62.

Calculation Steps:

First, convert R as a percent to r as a decimal

R = R/100

R = 3/100

R = 0.03 rate per year,

Then solve the equation for A

A = P(1 + r/n)nt

A = 10,000.00(1 + 0.03/1)(1)(30)

A = 10,000.00(1 + 0.03)(30)

A = $24,272.62

Summary:

The total value amassed, principal plus the interest, on a $10,000.00 principal at a yield of 3% per year compounded once per year for 30 years is $24,272.62.

 

THE COMPOUND INTEREST FORMULA

The moment one decides to deposit a certain amount of money to his bank account and let it parked there for a time for the compound interest, the computation of his foreseeable earnings should no longer be a mystery. If one resorts to do it manually, use this formula: A=P(1+r/n)^nt, where:

A = foreseeable earnings

P = opening balance

R = interest percentage (in decimals)

N = the number of times interest is compounded in a given period

T = time period

Meanwhile, there is another option. The internet was made for a more convenient life, so if you want to see your foreseeable earnings, go over any search engine and type 'compound interest calculator,' and that's pretty much it. Just fill in the necessary information correspondingly to the formula above.

 

KEY TERMS YOU NEED TO KNOW ABOUT COMPOUND INTEREST

Of course, one should not just know the formula on how to see his foreseeable earnings but should also be acquainted with the necessary variables related to compounding.

STARTING BALANCE. Simply put it as your starting balance. The principal of your account is the initial deposit you make when you open it, as well as any additional funds you deposit later.

INTEREST. Earned by combining the initial principal and accrued interest. You not only generate interest on your initial deposit, but you also generate interest on the interest.

FREQUENCY OF COMPOUNDING. Indeed, the recurrence of compounding is important. Quite frequent compounding intervals, like that of daily, produce more significant results. Search for accounts that compound each day when hoping to open a bank account. Although you may only see the rate of return added to your account on a monthly basis, the computation can still be performed on a daily basis. A few more accounts only evaluate interest on a monthly or yearly basis.

DURATION OR TIME. Compounding has a significantly larger impact over time. When money is left behind to thrive, you have a greater number of cycles or "credits" to the account.

DEPOSITS AND WITHDRAWALS. Withdrawals and deposits can both have an impact on your outstanding balance. Allowing your investment to grow or adding new deposits to your account on a regular basis will make the most sense. When you withdraw your investment returns, the correlation of compounding is reduced.

INTEREST RATE. The rate of interest is also a significant component in developing your outstanding balance over a period. Higher interest rates indicate that an account will grow faster, but compound interest can compensate for a reduced rate. An account compounding at a lower interest rate could perhaps cease up with a greater balance than an account using just a plain calculation, especially over long periods. Calculate the blow point and then do the math to see if that will happen.

 

SIMPLE INTEREST AND COMPOUND INTEREST CONTRASTED

Contrasting these two is very important. Simple interest works best in our borrowed loans, while compound interest works best in our savings account.

Now, as your bank pays interest on your original balance, this is referred to as simple interest. It's a simple formula: begin with the balance and multiply it by the rate of interest for the period you've chosen. That would be the value that the bank transfers into your account.

You have the option of withdrawing the accumulated interest. However, keeping the added money in your account will generate more interest income, compounding the initial interest payment. That is what compound interest means.

 

TAKEAWAYS YOU MIGHT USE

• Begin saving at a young age and deposit more frequently. Time is your key when it comes to growing your savings. Since compound interest matures money exponentially over time, the longer you can leave your money alone, the more will sprout.

• Numerous online deposit accounts are enticing since they compound on a daily rather than a monthly basis. Such accounts include American Express and Marcus by Goldman Sachs.

• Individuals can reap the benefits of compound interest as long as individuals have a return-generating account, and you should also look for the best interest rates.

• Many financial institutions reserve the right to modify the interest rate on a savings account at whatever moment. Consider setting up a certificate of deposit if you would like to earn compound interest at a steady rate for a set period.

• Compounding occurs when interest rates increased regularly. The first one or two cycles aren't terribly noteworthy, but events start to pick up after you keep adding interest.

• One more method for quickly calculating compound interest is the Rule of 72. By delving at the rate of interest and the length of time you'll earn a certain rate, you can get a rough idea of how long it will start taking to double your money. Calculate the rate of interest by multiplying the number of years by the rate of interest. If you get 72, you have a set of circumstances that will roughly double your money.

• Spreadsheets can perform all of the calculations for you. A future value calculation is typically used to calculate your final balance after compounding. This function is available in Microsoft Excel, Google Sheets, and other software products, but the numbers must be adjusted slightly.

• It is important to note that when you borrow money, consider that the lender doesn't use compounding for the interest since it will cause the borrower much more money and debt to return what was borrowed. More so, your savings and investments should be calculated using compound interest, while your debts should be calculated using simple interest.

 

Conclusion

Compound interest really has a magic that is both life-giving and death-dealing in saving and borrowing money, respectively. Remember that when you hear the term, the more straightforward explanation is that it is an 'interest on interest.'