What Is Compound Interest?
When it comes to managing your money wisely, understanding what compound interest is and how it works to your benefit can help you massively. In this piece, we'll break down exactly what compound interest is, how it works and why it can be so important for your financial life.
What is Compound Interest?
Compound interest is the process where the interest you earn in your savings accounts or investments also earns interest over time. Another way to best describe it is you earn interest not only on the initial amount of money you put into your savings account or investment but also on the interest that accumulates over time.
Think of it as "interest on interest." This compounding effect can significantly grow the amount of money you have, especially over long periods.
How Does Compound Interest Work?
Here’s a simple example to best show how compound interest actually works:
Imagine you deposit $1,000 into a savings account with an annual interest rate of 5%. After one year, you’ll earn $50 in interest, making your total balance $1,050. In the second year, however, you earn interest on $1,050, not just your original $1,000. This means you’ll earn $52.50 in interest for the second year, and your total balance will be $1,102.50.
This process will continue, and each year, the interest is calculated on the new balance, which includes previous interest. Over time, this leads to the possibility of huge growth on your savings or investments. Compound interest is the main reason why a number of money experts will recommend that you have a savings account and consistently put money into it each month that you can afford to then not touch so you can get the very most of the gradual increase in your interest as time goes on.
Key Terms to Know
Some good key terms to know when looking at interest or compound interest are;
Principal: The first amount of money you invest or deposit.
Interest Rate: The percentage of the principal that you earn as interest.
Compounding Period: The regularity in which the interest is added to the principal. These periods are usually annually, semi-annually, quarterly, and monthly.
Future Value: The amount of money you will have in the future after the interest has been added.
Why is Compound Interest Important?
Maximise Your Returns: The power of compound interest can really help increase your savings over time. The earlier you start saving or investing, the more you benefit from compound interest.
Save, save, save: Understanding how compound interest helps you can motivate you to start saving sooner and more consistently. The more money you put into your savings account, the more you’re going to be receiving each month.
Boosts Investment Growth: For long-term investments, compound interest can lead to substantial growth, making it a vital concept for building wealth.
Compound Interest vs. Simple Interest
It’s also important to know and understand the difference between compound interest and simple interest:
Simple Interest is calculated only on the principal amount. For example, with a $1,000 investment at a 5% simple interest rate, you’d earn $50 each year, regardless of how long you leave the money invested.
Compound Interest includes interest on the previously earned interest. This means your money grows faster over time compared to simple interest.
Tips for Maximising Compound Interest
Start Investing Or Saving Early: The sooner you start saving or investing, the more time your money has to grow through compounding.
Invest Regularly: Consistent contributions can make the most of the compounding effect.
Choose Higher Interest Rates: Look for savings accounts or investments with higher interest rates to maximise growth- GLOSS Vault can help you with this by showing you the highest interest savings account best suited for your needs.
Reinvest Earnings: Whenever possible, reinvest any interest or dividends you earn to take full advantage of compounding.
Summary
Compound interest can be a massive part of your financial life. By understanding how it works and applying it to your savings and investments, you can make the most of its benefits and build wealth over time. Start early, invest wisely, and let the magic of compound interest work for you.
Here at the GLOSS Vault, we have made it our mission to help as many people like you across Australia and New Zealand feel in control of your money and ensure you’re getting the most out of it. To find out more about us and what we do click here. If you’d like to see our app in action for yourself head here!