Interest, to give a very basic example, is the price that is paid to borrow money. Compound interest is when interest is added to the starting amount, or principal, so that the interest that has been added also earns interest.
With compound interest, you earn interest on the money you save and on the interest that money earns. Over time, even a small nest egg can add up to big money. Whether you realize it or not, the concept of interest plays a big role in your financial life because the possibility of earning interest is why people lend money. Interest makes borrowing possible.
What does this mean?
Your money can work for you when your money earns money. When your money goes to work, it may earn a steady paycheck. Someone pays you to use your money for a period of time. When you get your money back, you get it back plus interest. Your money can make an income, just like you. You can make more money when you and your money work.
Your Money Working For You: The Rule of 72
The Rule of 72 is a mathematical formula used to estimate the amount of time it would take for an investment to double. This formula is very useful because it helps you estimate how much time you need and what kind of interest rate you need to reach your financial goals.
The Rule of 72 Formula:
72 / interest rate = estimated years to double principal*
Example: 72 / 8% = 9 years to double principal at 8%
This example shows you how compound interest can work in your favor, by doubling your money after a certain number of years, depending the interest you are earning on your principal.
|Age||Every 18 years|
|Age||Every 9 years|
Compound Interest Can Also Work Against You
Just like you can earn interest on money you have, banks and other financial institutions lend you money to earn interest. Here is an example of how compound interest works against you.
If you have a $3,000 credit card balance at a 19% annual interest rate, and you only pay the required minimum balance of 2%**:
How long will it take to pay off the card?
At least 30 years
How many payments will it take?
Over 720 payments
How much will you pay in interest?
More than $8,500 in interest charges
All figures are for illustration purposes only.
*This is a hypothetical scenario used for illustration purposes and does not reflect the results of any specific investment. The actual time it will take an investment to double in value cannot be predicted with absolute certainty because investment performance usually fluctuates over time.
**Source: Credit Card Repayment Calculator, available at http://www.federalreserve.gov/creditcardcalculator/