4 Things Everyone Needs to Know About Compound Interest

Benjamin Franklin left $5000 to the cities of Philadelphia and Boston when he died in 1790. He stipulated that each city should create a fund that would last for at least 200 years. The idea was that the needy could borrow from this fund with a 5% interest. After 100 years, Philadelphia and Boston could withdraw $500,000 for the fund and leave the rest to work for the next 100 years. Was this an act of pure altruism on the part of Benjamin Franklin? Not exactly, his purpose was to help people to understand the notoriously impenetrable concept of compound interest.

What is Compound Interest?

Compound interest is the rate at which interest is applied to a loan. For example, when you apply for a loan, interest is calculated for the first period and then added to the total that you owe. After that, the subsequent period’s interest rate is applied to the gross number from the first period, rather than from the baseline. This process then continues until the loan is repaid.

Anyone Can Benefit

One of the big advantages of compound interest is that anyone can benefit from it. It isn’t some kind of obscure financial tool, it is something that is applied to most forms of investment and most bank deposits. If you want to work out exactly how much money you will earn on any deposits you make, or how much extra you will have to pay on a loan, then you need to learn how compound interest works.

It Can Work for Or Against you

Compound interest can either work for you, or against you. In order to understand this, let’s consider two different scenarios.

The first is debt. In this case, then whatever you owe will increase by a certain amount each year. Unless you pay off the entirety of your debt, the total amount you owe will increase every so often at predetermined intervals.

Second is a deposit. In this case, whatever money you deposit into a savings account will gain interest every so often, usually every year. After the first year, your deposit will consist of your original deposit plus the compound interest, and after the second year the compound interest will be applied to this new value rather than the original.

The Longer the Better

When you’re hoping to use compound interest to increase the value of your deposit, you will gain the most benefits on deposits that you are able to leave alone for an appreciable amount of time. If your deposit is expected to grow by 6% annually, for example, then it will double in value after 12 years. You can use this compound interest calculator to confirm that for yourself! If you aren’t able to leave the deposit alone long enough for it to mature significantly then you might want to reconsider the type of bank account you are using.

Compound interest is a notoriously complicated subject. If you’re still scratching your head over it, then check out this more detailed guide.