Building stacks with compound interest

Building stacks with compound interest

Blog #2 from our campaign "Financial tools' secrets" 

Become the next Einstein with this simple understanding!

Albert Einstein once described compound interest as the “eighth wonder of the world,” saying, “He who understands it, earns it; he who doesn't pays for it.”

When money makes money, and that money makes more money… we get compound interest!

Let us start off simple... Compound interest is when your interest builds on itself. If we put it into a simple example:

If you put $5 in a compound-interest savings account at 10% interest, it will earn 10% on the $5, which is $0.50. This then means, after year one, the account has $5.50 instead of just $5.

The more compound interest gets compounded, the fatter the stack! Let's take a look at how this works:

If instead of earning 10% interest, you compound your money at a compound interest rate of 10% per month (or 120% APR)-the annual compound interest rate is 12%. That means that after a year and a month, instead of $5.50 in the account, you'll have $20.62!

That's how compound interest works: The more compound interest you compound your money at, the more compound interest it can compound, and so on!

However, compound interest is not entirely free lunch. The main reason for this is that compound interest requires time. For example:

Let's say you invest $100 into a bank account that earns compound interest. You receive compound interest of 10% per month. You compound interest for a year and a month. Now, say you take your $100 out of the account, instead of leaving it in there to compound. In this case, compound interest will not compound because you have taken the money out. The next month you receive compound interest of 10%, which is from what your initial 100 dollar investment was before. This is because compound interest only compounds if the money stays in the account.

For the math’s boffins:

This is the formula for compound interest: A = P (1 + [r / n]) ^ nt

• A = the amount of money accumulated after n years, including interest
• P = the principal amount (your initial deposit or your initial credit card balance)
• r = the annual rate of interest (as a decimal)
• n = the number of times the interest is compounded per year
• t = the number of years (time) the amount is deposited for

Is it truly that wonderful?

It is also important to realise that compound interest can either be helpful or be hurtful... depending on if you're saving or borrowing. As previously discussed, when you are saving money, it is evident that compound interest will help you make more and more money over time. Unfortunately, the opposite applies to when you're borrowing money. Let's have a look at the case of any type of loan:

In this instance, you grow interest on any money you don’t pay back. If you don’t pay the interest charges within the period stated in your loan, they’re “capitalised,” or added to your initial loan balance. After that, future interest increases on the new, larger loan balance.

As you can see, compound interest can be a wonderful or terrifying way to make or lose more money.

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