Albert Einstein is said to have referred to compound interest as mankind’s greatest invention. Another claim is that he proclaimed it the most powerful force in the universe.
It has yet to be proven definitively that these words actually emanated from the renowned physicist. However, there is no questioning the fact that compound interest is indeed a powerful phenomenon.
Described in the simplest possible terms, it takes money to make money. While this is a wonderful thing when it’s working for you, it can be a fearsome adversary when it’s working against you.
Let’s look at how compound interest works.
Compound Interest v. Simple Interest
When you make a deposit or a purchase with simple interest, interest accrues based solely upon the principal amount in play. In other words, if you invest $100 at 10 percent interest, any interest earned will always be based upon that $100 — as long as it remains invested. Conversely, if you make a $100 purchase, the 10 percent interest charge will be applied to that $100 the first month and the remaining principal amount each succeeding month as the outstanding balance is paid down.
With compound interest, that $100 would earn $10 the first month. However, the second month interest would accrue on the principal amount, plus the $10 interest earned the first month. In other words, you’d earn interest on $110 the second month. This pattern would repeat for as long as you remained invested at the same rate. So, the third month you’d earn 10 percent interest on $121 and so on, and so on, and so on.
In other words, instead of calculating interest based only on the original principal, compounding interest calculates interest based on the principal plus any previous interest earned on that principal.
The Other Side of the Coin
Now, let’s say you have a credit card account and you carry a $100 balance forward into the following month. Additionally, the card issuer charges 10 percent compounding interest each month. This means the following month you’d owe $110, which would then be treated as the principal amount, which means the following month you’d owe $121 upon which interest would be calculated and added to the principal — causing your outstanding balance to grow each month.
Granted, your monthly payments would reduce the principal amount, however if they aren’t keeping pace with the growth engendered by the interest charges, you’ll owe far more than you borrowed in pretty short order. This is why when you’re trying to figure out how to get out of credit card debt, the first thing you need to do is pay far more than the minimum payment the lender requires. The required payments are set low specifically to give interest the opportunity to accrue.
Of course, the best way to avoid this altogether is to pay your credit card balance in full each month — before the end of the grace period — so interest charges cannot be applied to your principal balance. Otherwise, it just continues to grow exponentially.
A Double-Edged Sword
Again, when it’s working for you, you’ll love how compounding interest makes your investment grow. Yes, it starts slowly, but it builds upon itself over time like a perpetual motion machine slowly gathers speed and becomes unstoppable. In fact, given enough time, the amount of the compounded interest will surpass your principal investment to become the vehicle by which your fortune grows.
On the other hand, if you’re carrying a debt against which interest is applied on a compounding basis, you could well find yourself owing more for interest charges than you borrowed in the first place.
Long story short, understanding how compound interest works is key to making your money grow.