You know what a frenemy is, right? One second she’s inviting you out for dinner, and the next she’s talking about you behind your back. Ouch.
Well, you’ve got a financial frenemy too, and it’s called compound interest. Depending on the context, compound interest can help you reach your biggest financial goals … or it can put you deep in the hole.
That's why it's so important to understand compound interest: you can use it to your advantage and save yourself some serious money.
Not as Simple as Simple Interest
If you have ever taken out a loan or fixed mortgage, you’ve seen firsthand how simple interest works. Simple interest is a percentage multiplied by the amount you borrow and the length of time you promise to pay it back. For example, if you borrow $100 at an interest rate of 1%, and you have to pay it back in one year, the simple interest is $1. So you’ll pay back $101 when you’re ready. Simple interest, simple math.
But it’s completely different when interest compounds. This one little difference makes the added costs or benefits overwhelming. When interest is compounded, it is calculated as above with this small tweak: the calculation is done not once, but over and over again at set intervals, so it builds upon itself to make interest grow continually.
When We Love Compounding Interest
Compounding interest can work in your favor. For example, if you put $5,000 in a savings account with a 2% interest rate compounded annually—once a year—you will have $5,100 after the first year, $5,202 after the second year, $5,306 after the third year, and so on. After three years you will have made $306 just by putting your money in the bank and not touching it!
But if the interest is compounded every month instead of once a year, you will have more after three years: $5,309. Simply put, the more often something is compounded, the more interest that gets tacked on.
The $3 difference in this $5,000 investment may not seem like much. But the difference can add up quickly when you’re talking about large sums of money and interest rates that are 20% or more, which we are about to cover.
When We Hate Compounding Interest
While compound interest can be a saver's best friend, it's also what makes credit cards and loans so difficult to pay off. If you take out a $10,000 student loan that compounds annually at 5%, and you promise to repay it within three years, you will owe $10,500 after the first year, $11,025 after the second year, and $11,576.25 after the third year if you don't make any payments. Over the term of the loan, you’ll be paying almost $1,600 in interest! But that's nothing compared to the kind of interest you'll see on credit cards.
When it comes to credit cards, if you can’t pay your balance in full, you’re going to pay more interest next month on the interest you were charged this month. And unfortunately, the rate of compound interest on credit cards is always many times higher than what you get on your savings account. For example, if you owe $2,000 on a credit card with a 20% annual interest rate, you'll be charged at least $33.20 in interest each month—which is an unhappy few hundred bucks a year. If you're only making the minimum payment, that interest will continue to build and add up quickly. That’s why we always recommend you pay off credit card debt before you start saving for a big goal like buying a home.
Calculate How Much You’ll Earn (or Pay)
Because of the complicated nature of compound interest, it’s not as easy to calculate as simple interest. But you can use a handy compound interest calculator from Bankrate.com, which shows you exactly how much you’ll owe or make. Run it on every one of your loans and debts to understand how much you’re paying for carrying that debt. Then run it on your savings accounts.