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Compound Interest Explained
Compound interest can have a significant impact on your finances. Whilst it can positively affect your savings, it can also quickly increase the amount you owe on debt.
What is Compound Interest?
Compounding interest refers to applying interest on top of previously charged or earned interest. As a result, the interest gets larger over time.
Example:
If you had a savings account with £100 in it, earning interest of 10% per annum (I wish!), after year one, you would have £110, the additional £10 being from interest. After year two, you would have £121; you have earned another 10% on your new balance of £110 (£110 + 10% = £121). The process repeats, adding interest to the most recent sum of money.
However, the same concept is applied to interest owed on debt, such as a credit cards. When you pay back what is owed on the card, you may be required to pay back interest on what you borrowed, but also on any interest you have accrued over time. Unfortunately, interest rates for debt are far higher than those earned on savings, meaning the compound effect is more pronounced. As a result, what seemed to be small amounts of interest at the start can snowball into large amounts owed, so make sure you understand the interest repayments before taking out loans.
The Power of Compounding
Whilst the principle of compounding is simple, many underestimate the power of its effect over time. Whilst it can get people into a lot of trouble with debt, it is also the reason why many investors will say to start young, as even small amounts can grow into large amounts if held for long enough.
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