Compound interest makes your money work hard for you. But how does this process work exactly? When you earn interest on your money, the money you earned continues to cycle and generates additional profits. But the concept can be hard to grasp through reading alone – a visual example can help clarify the power of compound interest.
Earn interest on your savings
When you earn interest, your initial deposit grows by a little. For example, if you deposit $100 in an account that pays 2% annually, by the end of the first year, you should have $102. Clearly, the results are more dramatic with larger amounts, but start with what you have (and the number 100 is often easy for examples).
Earn interest on the interest
Every time the bank pays interest (whether that’s annually, monthly, or daily), you earn interest on your entire account balance. This includes the original deposit plus any interest profits that the bank has previously added to your account.
Earn more interest on the interest
The process continues as long as you keep your earnings in the account and continue to earn interest on your money. If you take money out of your account (like withdrawing interest and spending it, for example), the results are less dramatic. To get the full effect, you need to leave your account untouched, and the longer you wait, the more potential profits you can earn.
The magic of compound interest
Compound interest isn’t magic (even if it seems that way). It’s basic math. And practically, it’s just discipline and patience. The sooner you start, the better the results.
When comparing rates: When comparing bank accounts, you may encounter two types of interest rates. The “annual interest rate” tells you how much you earn on your balance over one year. This is useful when banking products pay interest once a year. The annual percentage yield (APY) tells you how much you earn over one year, but it is usually higher than the interest rate. If your account pays interest more than once a year (many accounts calculate your interest earnings daily), you can potentially earn more, leading to an increase in the annual percentage yield. Whenever possible, compare rates using the annual percentage yield as it takes compound interest into account.
So, now that you understand the concept, apply it to your finances. Start running some numbers to calculate exactly how much you can earn from compound interest. You can use online calculators or take the formula and calculate it manually. Look for ways to earn the best rates on savings accounts and similar vehicles. Learn how different types of certificates of deposit allow you to earn more (although you may need to lock in your money). Find out if using more than one savings account can help you leave your money alone to grow without intervention. Understand what you pay to use a savings account, even if you don’t pay any fees. Open a high-yield savings account to have a safe place to keep your money while it grows.
Source: https://www.thebalancemoney.com/example-of-how-compound-interest-works-4061815
Leave a Reply