What is the composed interest? What you should know

The compound interest, or what is known as interest on interest, is a method used by financial institutions, cooperatives, banks in general, lenders and credit card issuers to calculate the interest on an account or debt. What does this mean? That you could find it, for example, in your credit card or in your savings account.

Depending on where they are applied, compound interest may or may not be good for your pocket. Let’s see in a little more detail what compound interest is and what you should know about it.

What is the composed interest?

Compound interest refers to a method of continuously reapplying interest. The application of these interests is made on an amount (which we will know as the principal) that will grow over time.

Every time you don’t pay the full outstanding balance on your credit card, for example, you’ll notice how this figure continues to grow, even if you don’t use your card anymore. Why? Because revolving loans, like credit cards, work with compound interest.

However, interest on interest is not always a sure loss of money: it could also turn into an advantage. In what cases? Before a savings account, for example, or in a retirement plan or account. In this case, we would be facing a compound yield account, which is the same as compound interest, only this is a term that is reserved for instruments that allow you to earn money or generate profitability.

Compound interest on savings and investments

In the case of interest on interest on savings accounts, time deposits, mutual funds and retirement plans, time will be your best friend! Why? Mainly because you will put your money to “work” while you wait for it to grow without having to make extra deposits: it will only be enough to let it “feed on itself”, that is, on the interest that has already been generated in the past. and now added to the capital.

To calculate how long it will take for your money to double, just apply what is known as the rule of 72. This kind of “formula” will only give you an estimate, but it will be more than enough for you to get an idea of ​​how much return you could get in a savings account, for example.

Suppose you deposit $1 at a fixed annual interest rate of 10%. According to the rule of 72, you must divide 72 by the percentage applied (10) and the result will be the number of years it will take for your money to multiply by two. In this case, we would be talking about 7.2 years. At that time, the amount in your savings account will be $2.

This rule applies very well to mutual funds, also known as index funds, a figure that was invented by the pioneer John C Bogle, an American investor turned business tycoon, philanthropist, and founder of The Vanguard Group.

Bogle warned in his day that compound interest is unlikely to make you an overnight millionaire unless the rate is reasonable and you let time take its course. As long as the interest is high and you keep the money generated in the account, you will have more opportunities to multiply it quickly. The opposite will happen if it is low or you withdraw interest annually.

How to manage my savings?

In order to enjoy a higher return, it would be best to divide the savings into several accounts. The first thing you should do is find the highest paying savings account in the United States.

The second step, have a fixed-term deposit, for example, since they have a much higher interest rate than savings accounts.

In third place would be to diversify investments. Some people prefer to invest in the stock market, while others prefer to have an extra source of income, such as money received from rent, a website or a YouTube channel.

The faster you start investing (and saving), the less risk you’ll have to take financially and the more money you’ll be able to earn over time. The magic of compound interest is in allowing your money to grow little by little.

How does compound interest work?

To better understand how compound interest works, let’s see it in an example. Imagine that you deposit $100 in a investment account for your retirement. The interest applied to the account is 10% per year. At the end of the year, you will have $110. In the following year, you will start with a balance of $110, that is, $100 principal plus $10 interest. Suppose you decide not to make any withdrawals and keep that $110 in the account. At the end of the second year, you will have earned $11 in interest. Therefore, you will have $121 in total.

Note: According to the example, in the first year you earned $10 in interest because the only money you had on deposit was your principal. But, in the second year this figure grew and was fixed at $11. Why? Because it was added to the capital that you already had and also to the interest that you generated during the first year. In other words, that extra $1 represents compound interest.

Third year

Suppose you continue with your investment account open. So your third year starts with a $121 balance. Calculating an annual interest of 10%, at the end of the year you will have $12.10 in interest. Therefore, at the end of the third year you will have a total of $133.10. Note that your capital has been growing gradually: $10 the first year, $11 the second year, and now $12.10 the third year.

Fourth year

You enter the fourth year with $133.10. Since the interest is 10%, $13.31 in interest will be generated, which means that at the end of the fourth year you will have a total of $146.41. In this point, you have already earned $46 in interest. Considering that your initial capital was $100 – and you’ve come to get almost half of this amount in interest – it’s not bad at all.

What happens if I do not reinvest the interest?

Now, in this example you have always reinvested your interests. But what happens if you don’t? Basically, it would be like working with a simple interest. In the first year, you will get 10% return, as always. Therefore, at the end of the first year you will have $110. If you spend the $10 in interest—and keep the $100—you’ll earn $10 more in the second year. If you always withdraw interest, at the end of your fourth year of investment you will have won only $40 instead of $46.61, which is the figure we calculated in the previous example.

Perhaps with $100 you will not see a representative profit. But what if we increase this deposit to $10,000? Well, in this case, with an interest rate of 10%, you will earn $4,600 in four years. What if you deposit $100,000? We would then be talking about $46,000 in profit.

Note: It is important that you take into account that most investment accounts do not work with a fixed or consistent return, that is, the interest is not always unchanged. Therefore, that 10% could decrease or increase in the future. Regardless of this factor, there is no denying that compound interest is designed to build wealth, at least when it comes to investing.

In summary

Regardless of the amount of money you can save for the future in your savings account, and the interest, the longer you keep the initial capital and the interest generated, the more money you will get thanks to compound interest. This principle applies to accounts with 10% interest, 7% interest and even less.

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