What is compound interest? This is the interest you earn on interest.
As an example, let’s say that you have $100 and it earns 5% interest each year, you’ll have $105 at the end of the first year. At the end of the second year, you’ll have $110.25. You earned interest on the $5 you originally invested, but you also earned $0.25 on the $5 on interest.
Why is the concept of compound interest important? This is especially important over time, compound interest compounds over time. The longer you hold your investment in an interest-bearing account the more your interest compounds over time.
A cool rule to follow, the Rule of 72, which is a simple way to estimate how your investments will grow over time. By knowing your interest rate the Rule of 72 will help you estimate how long it will take for your investment to double over time. Simply stated take 72 and divide it by your rate of interest. For example, let’s say your interest rate is 9, 72 divided by 9 equals 8, your investment will double in about 8 years.
The components of compound interest are as follows:
- Principal – this is the amount originally deposited in a high compounding environment such as a high yield savings account.
- Interest Rate – this is the rate of interest paid on the account
- Compounding Frequency – The compounding frequency determines how many times a year the interest is paid. Usually, compounding only occurs monthly, quarterly or on an annual basis.
- Time Horizon – this is the amount of time over which the compounding can operate. The longer the time horizon, the more interest payments that will be made so that you’ll accrue a large ending balance at the end of your time horizon.