Generally speaking, compound interest is essentially interest that is earned on interest that has been earned previously. Although the concept may not seem to have a clear explanation, it is relatively easy to understand. Furthermore, compound interest is one of the most important financial concepts there are when it comes to increasing your savings in the long run.
Why is compound interest important?
Compound interest usually comes into play when you open a savings account. In time, it helps you generate increasing amounts of money without you actively doing anything. By using it, you are able to increase the money that you have in your savings account, even when you are not contributing to it. Over time, compound interest can help you reach a point where your savings account will generate enough income to live off of, to a small degree. However, this requires considerable contributions in the first 10-15 years.
What is compound interest?
The best way to explain the concept of compound interest is by looking at a simple example. If you open a savings account and deposit £10,000, this amount is called a principal. With each passing year, you will earn interest based on the principal. This means that with an interest rate of 2.4%, you will earn £240 every year. However, after one year, you will no longer have £10,000 in your savings account, but £10,240. This means that after the second year, you will earn interest based on the updated amount.
This new interest rate is called compound interest. Over time, the amount of money earned from interest will be added to your savings account and what you earn from compound interest will grow. In our example, after the first year, you would have £10,240 in your savings account. By maintaining the same 2.4% interest rate, you would receive £245.76. This new amount of money will be again added to the account and the compound interest would grow after the next year.
Compound interest for debt
Compound interest is also used by certain lenders. This means that you may be required to pay interest on interest that you’ve previously accrued. These loans are often financial nightmares if they span over the course of more than 3-4 years. When compound interest is charged on a loan, it basically means that the longer it takes to repay it, the more expensive it will be.
What is the best way to use compound interest?
Compound interest is great if you open a savings account and make regular contributions. If you start saving early on and try to make large deposits during the first 10-15 years, it is possible to reach a point where you will earn £10,000-£15,000 from compound interest alone. In many ways, a savings account that has a good interest rate can serve as an unending source of money (if you only take out the equivalent of your compound interest once per year) that you can use after you retire.
Earning money from compound interest also gives you a reason to never touch your savings account except for when you make deposits. After all, if you take money out of the account, the compound interest will be lower for the next year.
Overall, compound interest is one of the most important concepts when it comes to your financial life. It can work to your advantage, by earning you increasingly larger amounts of money with each passing year, but it can also make loans considerably more expensive than they initially appear.
As a rule of thumb, always look for savings accounts that have a high interest rate and for loans that do not have a compound interest rate attached to them.