Compound interest is a powerful concept, and it is important to understand how it can work for or against you.
Compound interest is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan.
Compound interest is often thought of as “interest on interest,” because it will make a deposit or loan grow at a faster rate than simple interest, which is interest calculated only on the principal amount. This example shows how compound interest can significantly boost investment returns on $10,000 over the long term.
While a $10,000 deposit that receives 5 percent simple interest would earn $5,000 in interest over 10 years, compound interest of 5 percent on $10,000 would earn $6,288.95 over the same period.
Conversely, compound interest can work against you if you have loans that carry high interest rates, such as credit-card debt. A credit-card balance of $20,000 carried at an interest rate of 20% (compounded monthly) would result in total compound interest of $4,388 over one year or about $365 per month.