What is Compounding and Why is it So Important?

What is Compounding and Why is it So Important?

Vocabulary

Interest: Money paid to you by a bank or financial institution when you keep money in an account there OR the extra money that you must pay back when you borrow money

Principal: The amount of money upon which interest is paid

Interest Rate: In savings, an interest rate is the price a financial institution pays for using a saver’s money and is normally expressed as an annual percentage of the amount saved

Simple Interest: Simple interest is interest earned on the principal amount only

Compound Interest: Compound interest is interest earned on the principal amount plus the interest already earned

The value of the dollar has gone down over time. You could buy a lot more with $1 fifty years ago than you can now. So, how can you make sure that the money you save is not worth less in the future when you need it? The answer is interest. When you invest money in a savings account, money market account, retirement account, or bonds, you will receive interest payments for allowing that financial institution to hold your money. These interest payments may be calculated using simple or compound interest, which can make a big difference over the long term.

While the difference between simple and compound interest may not seem that significant in the table above, over long periods of time, compound interest can lead to huge gains in the amount of your savings. In 54 years (the amount of time until you reach retirement age), the worth of that $100 deposit receiving 5% compound interest would be $1,393.87! With simple interest, the value would only be $370. The earlier you start investing, the larger these gains made through compound interest will be. Compound interest could be the biggest factor in whether or not you are able to achieve a secure financial future, because it makes your money grow!

However, compound interest can work against you just as drastically as it can work for you. This happens when you take out a loan. All of a sudden, you are the one paying the compound interest, rather than having it paid to you! Because of compound interest, people who take out loans and pay them back over time often have to pay back much more than they originally borrowed. It is very important to think carefully and understand the consequences of compound interest before taking out any type of loan, especially credit card debt.

The tool at the link below helps you to calculate how much compound interest will accrue over time in different situations. You will need to input the principal (the amount that was invested at the start), any ongoing monthly contribution, the amount of time that the money will be kept in the account, the estimated interest rate, and the compound frequency. You can also use this tool to figure out how much interest you will need to pay if you take out a loan. You will use this tool to complete your math assignment for today.

https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator

You can learn more information about simple vs. compound interest and their mathematical formulas here: https://www.investopedia.com/articles/investing/020614/learn-simple-and-compound-interest.asp#:~:text=Simple%20interest%20is%20calculated%20on,as%20%22interest%20on%20interest.%22