Understanding the power of Compound Interest- A Beginner’s Guide
What does it mean to you and your financial planning?
By now you’re probably well aware of the higher interest rates set by the FED starting in March 2022 – as you are seeing the impact of this in your daily lives such as higher interest rates for mortgages, credit cards and car loans. But is it all Bad news??
Have you considered the upside to this from a personal finance perspective? With interest rates at an all- time high it is important to understand the impact on your finances with respect to both opportunities and challenges. This is where it is important to understand the types of Interest being charged in various scenarios- and more importantly…how it can be a positive to your financial wellness.
As I have mentioned before in my Instagram posts, if you have not already taken advantage of a high yield savings account- you should .. RIGHT NOW! With higher interest rates, you can take that cash in your savings or emergency fund and put it in a High Yield Savings account –and here is why.
Simple vs Compound- What is the difference?
The primary difference between simple interest and compound interest is basically how the interest is calculated and applied to the principal over time.
What is Simple Interest?
Simple interest is calculated on the principal amount alone, not on any interest that has been added to the principal. It’s called simple- because if is easier to calculate and understand:
Here is an example:
Principal amount $1000
Annual Interest Rate: 5% (or .05 as a decimal)
Term of the loan=3 years
The amount of interest you would pay on that 3- year loan is $150 ($1000x.05×3=$150)
What is Compound Interest?
Compound interest is the interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods. This means that interest earns interest, leading to exponential growth over time. It is a little more complicated than simple, but basically means you are taking into account not only the original principal, but it is earning interest upon the interest.
When is it used?
Compound interest is typically used for mortgage calculations, credit card balances and savings accounts, where simple interest is used for car loans or short-term personal loans.
So, compound interest can really help you if you are saving and investing as the earlier you start the more time your money has to grow. Compound interest benefits significantly from long investment horizons, as even small amounts can grow substantially over time. But compound interest is not in your favor when dealing with loans (such as student loans or mortgages) as you are paying interest on top the principal as well as any earned interest charged. So be sure to check interest rate charged and the period of time of the loan- as both of these factors have a great impact on how much you are actually paying.
Here is an example of how compounding can work for you
Amount=Principal (1+interest rate) to power of length of loan ( 3 years) Principal =$1000 Rate=5% or .05 (decimal) Term= 3 years Here is a breakdown of the math!
Amount=$1000(1.05)3
(1.05)3≈1.157625
$1000×1.157625=$1157.63
So, after 3 years, the investment will grow to approximately $1,157.63. As you can see compounding can be very beneficial from a savings/investment standpoint – so get those high yield savings accounts open!
Yours in Financial Wellness!
Tara Taylor Financial
