From the course: Build Your Financial Literacy

Compound interest

From the course: Build Your Financial Literacy

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Compound interest

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- Compound interest, it could be your friend or your foe. What does compound interest mean and how does it apply to you? Turns out it is one of the most critical components for your personal financial wellbeing. Think of compound interest as interest on your interest. Simply put, its interest on the amount of money that you have deposited or borrowed. Compound interest is earned on the amount that you have deposited plus any interest that you have accumulated over time. It will make your sum grow at a fast rate, that is, it is compounding than simple interest, which is calculated only on the principle amount which is the initial amount of money that you've borrowed or invested. For example, let's say you deposit $50 into your bank account and the bank pays you 5% annual interest. This is their way to say thank you for doing business with them by keeping your money at their institution. If you choose not to do anything further with that bank account, your money will still continue to make money for you. Let's take a look at how this works. So during year one you have $50 at 5% annual interest. This will equal $2 and 50 cents in annual interest that is deposited back into your bank account. At the end of the year, you will have $52 and 50 cents. Now for year two, you start with $52 and 50 cents at 5% annual interest. This means you'll gain $2 and 63 cents in annual interest deposited to your bank account for a total of $55 and 13 cents. Finally in year three, you will have $55 and 13 cents at 5% annual interest initially, giving you $2 and 76 cents in annual interest deposited into your bank account. At the end of that year, you'll have $57 and 89 cents, and so on. This is a beautiful thing, who doesn't want earn money on their money and not have to lift a finger? If you're borrowing however, compound interest will benefit the lender, not you. When borrowing money compound interest is charged on the original amount you were loaned plus the interest charges that were added to your outstanding balance over time. Wondering how this works? Take a look at this example. Suppose you borrow $10,000 at a 10% annual interest rate with a principal and interest that's compounded annually due in three years? At year one, you've borrowed $10,000 at 10% annual interest, which equals $11,000 that you now owe. At year two, you've got $11,000 at 10% annual interest, which equals $12,100 that you now owe. And at year three is now $12,100 at 10% annual interest for a total of $13,310 that you now owe. As you can see a compound interest in a loan is no joke. You borrowed $10,000, but because of compound interest, you not only owe the $10,000 that you borrowed, but an additional $3,310 interest to the borrower. Bottom line, compound interest can be your friend or your foe depending on whether you're investing or borrowing funds.

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