Compound interest is not exciting. However, it is essential to most financial systems.
Basically, it is money that lenders earn. For example, a savings account might pay you compound interest for lending money to the bank. You might pay this type of interest to a credit card if you maintain a balance past the statement due date.
Compounding is unique because lenders earn a percentage of the money — and then they earn a percentage of that percentage later on. The U.S. Securities and Exchange Commission has an easy-to-use calculator that helps predict costs. To get an idea of how compound interest works in your specific situation, you might try plugging in your own information after reading this article.
Principal
Imagine that you needed to take out a loan. Your bank had the money you needed. That amount would become the principal. It is the starting amount.
Interest rate
The bank might say that you have a 5 percent annual interest rate. That means that you would pay 5 percent of the money you owe them.
Period
To calculate compounding interest, you need to have a time period. This is why you usually pay more than the stated percentage rate.
For example, the bank might say that your interest compounds monthly. They would take the total you owe at the end of the month, add one month’s portion of 5 percent (a little less than half of a percent) and then use that as the new amount you owe.
Total amount owed
The amount that you owe depends on the principal, the rate and the amount of periods. Higher numbers in any of these categories would lead to more debt.
With lower interest rates, such as those that banks pay for savings accounts, you do not see much change in the total. Credit cards, on the other hand, accrue interest very quickly.
Generally speaking, financial institutions lend money at high rates with the expectation that they get more money back in the future. They borrow money at much lower rates. This often leads to unfortunate situations, especially when interest rates are high and consumers do not understand their obligations. Luckily, there are various debt relief options available in most cases.
We are a debt management agency. We help people file for relief under the U.S. Bankruptcy Code.
