One of the most constructive, and destructive, forces in finances is the power of compound interest. Compound interest is interest that is not only paid on the principal, but also on the interest that previously accrued on your investment. On the other hand, compound interest can work against you — for instance, as finance charges against your credit card debt that could quickly snowball out of control. It can be a great burden, or a great boon. It all depends on the money choices you make.
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Compound interest can be a great gift to you if you avoid debt and get into the habit of saving your money. A high yield savings account can get you a 1.35% annual yield, but if you look into longer term certificates of deposit, you can get around 3.00%. And if you invest for the long-term in diversified investments, you can expect an even higher average annual returns.
When you put money into interest bearing accounts, or dividend yielding investments, you get paid for letting your money sit there. For example, if you have $1,000 and average 4.00% APY across your savings and investments, after a year, you’ll earn $40 in interest and dividend. If you let your money sit in your savings account and reinvest the dividend, the following year you will earn $41.60 — doesn’t sound like much, but your original $1,000 will turn into $1,423.31 after 10 years, $2,106.85 after 20, and $3,118.65 after 30!
One of the most destructive examples of how compound interest can work against you is credit card debt. Every month your interest charges are added up and then tacked on to the balance. Pretty soon, you are paying interest on your interest and barely reducing the principal at all — especially, if you only pay the minimum. In fact, it is possible to pay back many times what you originally borrowed when you are only paying the minimum.
Other loans charge compound interest as well, but credit card debt is the most devious. It can also be one of the most difficult to get out of, since the interest rates charged are so high, and in some cases the interest is compounded daily.
Consider your financial choices carefully. You want to be making compound interest work for you, rather than working against you.