Compound Interest Explained

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Compound interest will have a different meaning to you depending on whether you are a spender or a saver. Compound interest can be your worst enemy or your best friend.

Here is the thing: How you treat compound interest is how compound interest will treat you in return.

Make compound interest work for you and you will reap the benefits of the financial freedom it creates. Allow it to take control and you can find yourself financially restricted for years – maybe forever.

 

What is the difference between simple interest and compound interest?

Simple interest is, to put it simply, simpler! You have an amount – let’s say £100 – and at the end of a period of time a percentage of interest is added to that £100. If, for example, your £100 was to earn 12% interest at the end of one year it would be worth £112.

Compound interest – or cumulative interest as it is also known – does as its name suggests and compounds. This means that instead of only adding interest to the initial amount, interest is added to the initial sum plus interest. Then it adds interest on the initial sum plus the interest plus the interest… And it continues to grow – or compound – until the term is up – or until the debt is paid. If the £100 example above earned compound interest it would be worth £112.68 at the end of the year instead of only £112.00.

 

But is compound interest a good thing or not?

That depends.

This is how compound interest works if you owe money. Let us use an example of a £100 debt, with a minimum payment of 3% a month and an annual interest rate of 12% (or 1% a month).

 

Month 1 balance: £100.00

You pay 3% minimum payment of £3.00

The debt is now £97.00

You are charged 1% interest: 0.97

The debt is now £97.97

 

This is what happens in month 2:

Month 2 balance: £97.97

You pay 3% minimum payment of £2.94

The debt is now £95.03

You are charged 1% interest: £0.90

The debt is now £95.98

 

Then comes month 3:

Month 3 balance: £95.98

You pay 3% minimum payment of £2.88

The debt is now £93.10

You are charged 1% interest of £0.93

The debt is now £94.03

 

So far you have paid £8.82 but you have only paid £5.97 of the debt off. £2.85 worth of payments has only been paying off the interest. Even if you were to pay £3 each month which is over the minimum 3% a month required, thanks to compound interest your debt would take 41 months to pay off.

 

But what happens if you were to invest that £100 in an account paying 12% per annum – or 1% a month?

Let’s see:

 

Month 1 investment amount: £100.00

Add interest at 1% of £100.00: £1.00

Balance: £101.00

 

Month 2 investment amount: £101.00

Add interest at 1% of £101.00: £1.01

Balance: £102.01

 

Month 3 investment amount: £102.01

Add interest at 1% of £102.01: £1.02

Balance: £103.03

 

If you were to save that £100 at the same rate of interest rather than owing it you would make £3.03 in three months.

 

So to answer the question: ‘Is compound interest good or bad?’ we just need to look at the following:

 

A £100 debt with an interest rate of 12% per annum repaid at £3 a month would take 41 months to pay off.

A £100 investment with an interest rate of 12% per annum would be worth £146. 73 in 41 months.

Which method of compound interest would you rather have experience of?

 

Compound interest will behave according to how it is treated. The question is, will you make compound interest work for you, or will you continue to work for it instead?

 

 

 

 

 

 

 

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