When people talk about saves and investments, they might use the word “compound interest.” Basically, it’s interest made on interest already earned.
What? #
Don’t worry if it sounds a little hard to understand. It’s really not that hard to understand. It’s important to understand what compound interest is because it can have a huge effect on your money over time.
How to understand compound interest #
If you save money, you’ll probably get interest on it. You’ll make more interest on top of the interest you already have. This is called compound interest.
This is an example #
Let’s say you put £1000 into a savings account that paid 1.5% AER/Gross a year in interest. You would get £15.10 in interest in the first year. The amount you earn would go up in the second year, though, even if the yearly interest rate stays the same.
Why? Since interest will have built up over time. The amount of money you save will grow over time, and it will grow faster as well.
What good does it do? #
With compound interest, your savings can keep growing even if you don’t add to them. This is especially true if you keep them for a long time. This is the reason why a lot of family and financial experts tell you to start saving money right away.
In this case, let’s compare two things #
- From the age of 30 until he turns 60, James saves £100 a month, which earns him 10% a year. James will save £217,132.11 all together.
- But Alex starts putting away £100 a month when they are 20 years old and stops when they are 30. They save the money until they are 60 years old. Alex earns a total of £367,090.06
- That’s how helpful interest that builds on itself can be. If you start saving early, saving for 10 years may be better than saving for 30 years some of the time.
Interest that builds on loans #
It’s too bad that compound interest doesn’t just work on savings accounts. Compound interest can also be charged on some kinds of loans and borrowing.
On some credit cards and loans, for instance, you may have to pay interest on interest that you’ve already paid. An amount of money saved can grow over time even if you don’t add to it. The same is true for a small loan that you don’t pay off.
