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The Most Important Financial Terms Everyone Should Know: Compound Interest

Compound interest is simple: you earn interest on interest. Ok, I guess I could see how that could be a little confusing. Let’s see, how can I relate this to something most people with understand? Ok, let’s use a simple lie as an example. You know how one little lie usually leads to having to tell another lie to have a convincing story for the initial lie. Then another and another and then you have this crazy outlandish story about how the reason you were running late to all of your meetings and appointments today is because your dog threw up and you had one, NO….TWO flat tires today. Oh and you also got pulled over for speeding. You get the idea. That’s pretty much how compound interest works.

 

Here is a real example with some numbers. Say you have a $1,000 that earns 10% interest in one year, and increases by $100. Its value is now $1,100. The next year, it goes up another 10%—but this time the amount that is earning and collecting interest is higher. Your $1,100 is now increasing by 10% which has grown to $1,210 by the end of the second year. You money will continue to grow faster and faster each and every year.

 

Compound interest is pretty great but it can also work against you in the form of debt. Why do you think credit card companies and mortgage lenders tend to be so profitable? If you only make the minimum payments on your debts then you are being charged interest on top of interest and will end up paying significantly more than the initial debt.

 

Why You Need to Know This

Compound interest is one of the most powerful forces in the universe. It can cause you to get buried in debt or make you wealthy while you sleep. And the best thing about compound interest is that if you are already saving and investing you don’t have to do anything to benefit from it. Compound interest might be the most important financial concept everyone should learn. The chart below shows the powerful effect compound interest can have using the power of time to increase earnings and savings.

 

 

If you’re still a little fuzzy on what exactly compound interest is and what is does then check out this short six minute video from Khan Academy.

2 thoughts on “The Most Important Financial Terms Everyone Should Know: Compound Interest

  1. With even “high-yield” savings accounts earning only 1.25% or less for the past several years, are there any better options for investing money and earning compound interest with little risk (similar to a savings account)? For people saving for a big purchase in a few years (like a house), I don’t think it makes sense to put that money in the volatile stock market. However, it seems like the interest accruing in my savings account at my current 1.05% is a pretty poor return when adjusting for inflation. What do you think?

    1. That’s pretty much what every investor wants – good returns with low risk in just a short period of time. A large majority of money will still have to come fro pura savings rather than investment return. Especially on a shorter timeframe.

      Anyway, here are three pretty decent options: 1) Certificate of Deposit (CD), 2) a Short-Term Investment-Grade Bond mutual fund, or 3) Series I Savings Bonds.

      1) CD’s – The going rate is near 2% annual return if you can commit to at least three years.

      2) Mutual fund – Check out Vanguard’s VFSTX. It is a short-term bond fund that pays out close 2% every month and if you look at the historical price it does not fluctuate very much at all. Link to fund in formation: https://personal.vanguard.com/us/funds/snapshot?FundId=0039&FundIntExt=INT

      3) Series I Savings Bongs – You can get 2.76% annual return here. Check out the U.S. Tresury’s website for more info on them here: https://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_ibonds_iratesandterms.htm

      Any of these should give you slightly higher returns than savings accounts. But they won’t be as liquid if you needed to access the money very quick for some reason. With a little planning and foresight any of these should work well for the situation you described.

      Good luck!

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