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What is compound interest and how is it calculated?

Interest is the money paid to you by your financial institution to reward you for banking your savings dollars with them. Compound interest is the simple equation which could help amass more dollars in your savings account.

Albert Einstein referred to compound interest as the 8th wonder of the world and will likely be the biggest impact on your financial future.

What Is Simple Interest?

Interest rates are typically represented as a “percentage per annum” (you may see is at X% p.a.). This describes how much interest will be paid on the principal per year.

With simple interest, you would merely work out what that percentage would equate to over the 12 months. For example, if you were depositing $1,000 in an account that earned 3% interest, with simply interest, your balance would be $1,030 a year later.

Earn Interest on Interest

The element that sets compound interest apart is that you earn interest both on the money you’ve deposited as well as on any interest already paid to you – so you earn interest on interest.

This can greatly impact your total your savings over time. Taking the above example, if you deposited $1,000 in an account earning compound interest, calculated and paid monthly, you would have $1,030.42.

Whilst that 42 cents may seem a little insignificant in this example, with additional savings deposits into your account and over a longer term, your balance can significantly increase as compound interest works for you. There are a number of free compound interest calculators to assist you in calculating the amount of interest you could earn.

Compound Interest Can Work Against You

Within the context of a savings account, compound interest is your best friend – slowly and steadily helping you accrue larger interest payments. However, when you are the borrower paying back a loan or credit card, you will most likely be paying compound interest.

It’s important to realise how this will affect you in situations such as credit cards and home loans, where the shoe will be squarely on the other foot. Complacency with debt can be an inhibitor to your financial goals, so be sure to seek professional advice from an experienced lender or Broker when taking out credit of any form.

 

Disclaimer: The ideas, discussions, options and details expressed in SCCU Blogs are for general informational purposes only and are not intended to provide specific personal advice or recommendations for any individual or on any specific security or investment product. We intended only to provide education about the financial and banking industry to make the complex simple, and help everyday customers realise their dreams.

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