If you want to manage your finances, than one of the most important concepts for you to understand is Compound interest. It goes both ways, it can make things worse when you have interest compounding on money you’ve borrowed, but it can also help you earn a higher return on your investments and savings.
What Is Compound Interest?
Compounding is a process of growing. You already know how something can build upon itself, if you’re familiar with the “snowball effect.”
How Does the Concept Work?
CI is interest earned on money that was previously earned as interest. This cycle leads to increasing account balances and interest at an increasing rate, sometimes known as exponential growth.
Start with the simple interest’s concept: you deposit money in the bank, and in return the bank pays you interest on it. For example, you might deposit $200 for one year at 10 percent, and you’d earn $20 in interest over the year.
What happens next year? Here compounding comes in. You’ll start earning interest on the deposit you made initially and you’ll earn interest on the interest you just earned:
You’ll earn 10 percent on your original deposit $200 again.
You’ll earn 10 percent on the new $20 of interest earnings the bank paid to your account.
That means you’ll earn more than $20 next year because your account balance is now $220, even though you didn’t make any new deposits in the bank, so your earnings will accelerate. At many banks (especially online banks), the process moves even faster as interest compounds daily and gets added to your account monthly.
Compounding works against you, if you’re borrowing money. You pay interest on the borrowed money, and your loan balance can increase over time, even if you don’t borrow any more money.
How to get started investing with compound interest?
Bank accounts earn compound interest: Most savings accounts key feature is the interest they pay, which is typically higher than the interest you can earn on checking accounts; many checking accounts pay no interest at all.
You can also earn compounded interest in certificates of deposit (CDs) and money market accounts.
Some bonds earn compound interest: A fixed interest sum is paid by many bonds, but some, like zero coupon bonds incorporate compounded growth. A typical bond might have you paying the face value of the bond (which might be $10,000), and then collecting regular interest payments, often referred to as coupons, before getting the face value back at maturity. With a zero coupon bond (even though its face value might be $10,000), you’ll pay less for it, such as, perhaps, $9,500. You’ll receive no interest payments, but at maturity, you’ll collect $10,000, not the $9,500, with the difference representing the compounded value of interest payments.
The power of compounding in non-interest-bearing investments: Investments like GICs, bonds and savings accounts pay interest. You know exactly how much money you’re going to earn, with these types of investments. You can still benefit from compounding by reinvesting your earnings on other investments, like mutual funds, exchange-traded funds (ETFs) and stocks. If you hold any of these investments within a registered account like a tax-free savings account (TFSA) or registered retirement savings plan (RRSP) you may be able to reduce or eliminate the tax you pay on your earning