Albert Einstein once called compound interest, “the greatest invention of mankind,” and we have to agree. Compound interest may just be the greatest invention of all time. It might even be mathematical magic!
Often when people think of interest, debt interest is the first thing that comes to mind. This is most commonly the interest owed when you don’t pay off credit card and loan balances. Interest can actually work in your favour when you’re earning it on money you’ve invested and continue to reinvest.
There are two main types of interest: simple and compound. We’ll explain the difference here using the math outlined in Get Smarter About Money’s resource. We’ll also explain the differences between good and bad interest.
How the Good Interest Works
Investment Scenario Breakdown
- Starting Balance: $1000
- Investment Duration: 2 Years
- Interest: 5%
Here’s an example that explains simple interest. To keep the math easy, let’s say you start with investing $1000 and earn 5% interest annually for 2 years without reinvesting the interest you earn. At the end of that 2-year term, you’ll have an extra $100 using simple interest. That’s calculated by adding your initial investment ($1000), plus the $50 of earned interest for each of the two years you were invested. Simple, right? Compound interest works a bit differently.
Compound interest resets our starting balance and reinvests any of the interest earned. Assuming you’re investing that same $1000 in this scenario, after 2 years you will have $1102.50 thanks to the powers of compound interest. How is this calculated? Your starting balance is reset each year when you reinvest the interest earned.
That means that on your first year invested, you’ll earn that same $50 on your investments, giving you the same total of $1050 at the end of your first year. But that $1050 is then reinvested for your second year at 5%, meaning you earn a return of 5.25% over the two year period.
Although these numbers don’t seem like a great deal of earnings, trust that you really will feel the impact of that extra quarter. Over time the compound interest earned by resetting and reinvesting your balance has the potential to significantly grow your nest egg. How does compound interest work negatively? We’ll explore this now.
How the Bad Interest Works
Loan Scenario Breakdown
- Starting Balance: $1000
- Duration: 2 Years
- Annual Interest Rate: 20%
We wanted to include the negative power of compound interest as well, so here’s the story of those same $1000 dollars owed on a credit card or loan. We’ll apply the same 2-year duration with a typical annual credit card interest rate of 20%. With a balance of $1000 dollars and paying 20% interest, and assuming you don’t make payments over the year, you’ll owe $1200 at the end of your first year.
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In your second year, you’ll owe $1200 in addition to 20% interest (additional $240), bringing your debt to a total of $1440. The calculations continue until your balance is paid off. Scary stuff, right?
The Power of Time and Interest
In short, compound interest is essentially interest earned on interest. It’s perhaps the easiest way to put your money to work without doing a thing, and if you’re paying interest on a loan, it can be a very slippery slope if you don’t make the sacrifices to pay off your balance in full as early as possible.