By M Katie Helle, CPA –
As you start to manage your finances, it is important to understand interest, whether it be interest you are earning on your savings or interest paid on money borrowed.
So you may be asking yourself what exactly is compound interest? According to Investopedia, compound interest is “interest calculated on the initial principal, which also includes all of the accumulated interest of previous periods of a deposit or loan.” This basically boils down to the process of growing or what is often referred to as the snowball effect, which is where something continually builds upon itself. For example, let’s say you deposit $100 into your savings account. The bank is offering 5 percent interest on the account. On your $100 deposit, you would earn $5 ($100 x 5% = $5.00). If you keep the interest earned in the account, the next year, you would earn 5% on the $105, which would earn you $5.25 ($105 x 5% = $5.25). Do you see the snowball effect here? The balance would continually grow the longer you leave the initial deposit plus the earning in the account.
When it comes to earning or paying interest, it is always important to shop around. When you are earning, you want to get the highest rate of return, meaning the higher the interest rate, the better. When you are borrowing, you want to shop for the lowest rate, meaning the amount of interest you pay is less.
What are your experiences with compound interest? Are you earning interest or paying it?