When discussing interest, there are various factors to consider. And the two main types you should focus on are fixed-rate interest and compound interest. In this article, we’ll dive into the later.
What is Compound Interest?
Compound interest (CP) can apply to both borrowing and saving. When it comes to loans, CP means that the interest you owe increases over time. This essentially means you’ll pay more in interest as the loan progresses, either yearly or even monthly.
Your principal is the original amount of money you borrowed. Then there’s the interest – it’s what accrues on that principal over time. With CP, the interest itself accumulates more interest. That in turn is leading to a higher total repayment amount if you don’t pay off the loan early.
Consider this example – you borrow $1,000 with a 20% annual compound interest rate. You’ll owe the principal plus 20% interest at the end of the first year. This process continues year after year. After three years, your $1,000 loan could grow to $1,728 due to the compounded interest.
For home loans, the CP rate is usually much lower, often under 10%. You can reduce the interest you owe in several ways, such as making a larger down payment (which reduces the loan amount), improving your credit score to get a better rate, paying off the loan faster, or refinancing when better rates become available.
Compound Interest in Savings
The concept of CP works similarly for savings. You earn interest on your initial deposit, and over time, that interest earns interest as well. For example, if you deposit $100 in a savings account with 1% quarterly compound interest, after the first quarter you’ll earn $1, making your total $101. In the next quarter, you’ll earn 1% on $101, and so on. Over time, your savings grow faster than with simple interest.
Is Compound Interest Good?
When it comes to saving, CP is highly beneficial. It helps your money grow over time without any extra effort. If you’re looking for a passive way to increase your savings without taking on the risk of investing, compound interest is a great option.
However, when it comes to large loans, like home or car loans, CP isn’t as favorable. It can cause you to pay significantly more than the amount you initially borrowed. To mitigate this, you can try to pay off the loan faster, which reduces the amount of interest that compounds over time.
Before making extra payments, though, it’s important to check if your loan has penalties for early repayment. Some loans require you to wait a certain period before paying them off early to avoid these fees. In other cases, paying your loan off sooner can save you a significant amount in interest.
Why Does Compound Interest Exist?
For savers, CP is designed to help you grow your money more quickly. It allows you to earn more on your savings as time goes on. For lenders, compound interest serves as a way to earn more from the money they lend, and it also encourages borrowers to repay loans faster.
If you take out a loan with compound interest, the best strategy is to pay it back as quickly as possible. This will minimize the total interest you end up paying, allowing you to focus on repaying the principal.
For savings accounts, CP may not lead to massive gains, but it’s a reliable way to passively grow your money. Many banks offer compound interest to attract customers to open accounts with them.
Whether you’re borrowing or saving, compound interest isn’t always involved—many loans come with fixed interest rates. It’s crucial to understand the terms of your loan fully, including how interest will be calculated, so you’re aware of the total amount you’ll end up paying over the loan’s duration.
References
1. Consumer Financial Protection Bureau. “What is compounding interest?”
2. Board of Governors of the Federal Reserve System. “Consumer Credit – G.19.”
3. U.S. Securities and Exchange Commission. “Compound Interest Calculator.” Investor.gov.
