What is compound interest, and is it good or bad?
Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.
That saying, which some attribute to Albert Einstein, describes compound interest perfectly.
What is compound interest? If you have a savings or investment account, it’s money you earn from your interest. That’s a good thing.
If your loan has compound interest, it’s interest that’s charged on your interest. That’s a bad thing.
Let’s take a closer look at compound interest in a savings account. Say you have a savings account with $1,000 in it and you earn 6% APY – that stands for annual percentage yield. With simple interest, you’d just earn $60 off your $1,000 in one year. But because of compound interest, you earn more.
Let’s break it down. Each month, your account earns 0.5% interest, which is $5. So at the end of the first month, you have $1,005 in your account. So the next month, when you earn 0.5% interest, you’re earning it on $1005, which is $5.025 (we’ll round it up to $5.03) instead of $5. Because of compound interest, you’ve already earned an extra three cents. Your new balance is $1,010.03, which earns you $5.05 in interest. You picked up an extra two cents for a new balance of $1,015.08. Over time, those couple of cents add up and you earn more and more. That’s why they say to begin saving for retirement when you’re young, because over a period of 40 years, compound interest really adds up.
Now let’s look at the dark side of compounding interest. Let’s say you have a $5,000 balance on a loan with compound interest, and it has a 15% APR – that’s annual percentage rate – and it compounds daily. If you wait 30 days to make your first payment, your balance will already be up to $5,063.70. That means even if you made payments of $63.70 every month, the outstanding balance would stay the same for the rest of your life.
As you can see, compound interest can be very expensive. That’s why so many financial gurus advise you to pay off your credit cards first if you’re trying to improve your finances. Car loans and personal loans typically have simple interest, not compound, so there’s a better deal. Mortgages have simple interest but they make you pay it all up front, so it takes much longer to pay down your principal. (Principal is the original amount you borrowed.)
Make sense? Remember – compound interest in savings is good. But in a loan, it’s bad for your budget.