The power of compound interest on your savingsThere are many key concepts to take into consideration when managing your finances, one of which is compound interest.
By understanding the effect and benefit of compound interest, you'll be able to earn a higher return on your savings and investments.
When it comes to the interest you pay, compound interest can work against you when paying interest on a loan.
What is compound interest?
Compound interest is defined as the interest earned on money saved that has previously earned interest. This cycle leads to increasing interest and account balances causing exponential growth in savings and investments.
How does compound interest work?
To understand compound interest, let's look at the concept of simple interest:
You deposit money, and the bank pays you interest on your deposit.
For example, if you earn a 5% annual interest on a deposit of R100, you would gain R5 after a year. What happens the following year? That's where compounding comes in. You will earn interest on your initial deposit, and you will earn interest on the interest you just earned.
Therefore the interest you earn the second year will be more than the year before because your account balance is now R105, not R100.
How can compound interest benefit you?
We know that you have different saving goals and that there is only so much that you can save each month with your monthly expenses. Compound interest facilitates faster growth of the money that you are putting away in a savings account. As demonstrated above, the interest that you'll earn is calculated on the accumulated interest over time.
Compound interest can create a snowball effect, as the original savings and the additional earned income from those investments grow your savings together.