Understanding Compound Interest: May the force be with you!

Posted on 14. Feb, 2011 by Alissa Alvarez in Tax Financial Planning

We can’t see it, touch it, hear it, smell it, or taste it. However, this invisible force is affecting you every day either for the better, or for the worse. Do you know what it is?

If you guessed the VW Darth Vader kid, then you were close! The invisible force is, however, Compound Interest, and you are either using it to your advantage, or letting it take advantage of you.

This isn’t the most jazzy of subjects, but it’s an important concept to understand as it affects you daily. In this article, I will quickly go over what the basics and how it works.

What is Compound Interest?

It is the interest a person earns on his original investment, plus all the interest earned on the interest that has accumulated over time.

In order to get a better understanding, let’s first take a look at how Simple Interest works. Think of it as interest earned on your original investment. For example, assume the scenario in which you are investing your savings of $10,000 and earning 5% simple interest over three years:

SCENARIO ONE: SIMPLE INTEREST

Year 1:

$10,000 x  5% = $500

In Year 1, you will have earned $500. You’ll also earn $500 in Year 2, and another $500 in Year 3.

$500 + $500 + $500 = $1500

$10,000 + $1,500 = $11,500 Total

At the end of three years, you will have earned a total of $1500 on your original $10,000 investment for a total of $11,500. Not too bad, right?

Now, we will take a look at the same scenario but using Compound Interest instead.

SCENARIO TWO: COMPOUND INTEREST

Year 1:

$10,000 x  5% = $500

In Year 1, you will have earned $500. Initially, what you earn will be the same in the first year as what you would using Simple Interest. But from here on out, you will add that earned interest to the accumulated amount being invested.

Year 2:

$10,000 +  $500 = $10,500 new accumulated amount for Year 2

$10,500 x  5% = $525

In Year 2, you will have earned $525.

Year 3:

$10,500 +  $525 = $11,025 new accumulated amount for Year 3

$11,025 x  5% = $551.25

In Year 3, you will have earned $551.25.

$500 + $525 + $551.25 = $1,576.25

$10,000 + $1,576.25 = $11,576.25 Total

At the end of three years, you will have earned a total of $1576.25  on your original $10,000 investment.

Total:

$1,500 = Total Simple Interest earned

$1576.25 = Total Compound Interest earned

$1,576.25 – $1,500 = $76.25 Difference

By using Compound, you will have earned $76.25 more than you would have by just using Simple.

The “force” only gets stronger with every year that passes. As a homeowner, you need to understand how compound interest works.

The only way to fight the force and win, is to pay your mortgage off quicker by making extra principle payments.

Credit cards, auto loans, student loans and more are all vehicles of Compound Interest. How is The Force affecting you? Is it for the better, or for the worse?

*Please keep in mind that all the information I post on this site is for general purposes only. I understand that every person’s situation is unique and should be treated as such. If you would like more information about how something listed in any of my posts specifically affects you, please feel free to comment below. For additional financial advice, please speak with your local financial professional.

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• How to Double Your Money Using “The Rule of 72″

The Author: Alissa Alvarez

As part of the information hungry, and fast paced Generation Y, I provide an interactive service that is tailored to educate and empower the First Time Homebuyer. In a past life I was a fully licensed financial planner, and enjoyed teaching the basics of personal finance to the community. Unfortunately, today's industry doesn't allow me to be both a mortgage professional, and a financial planner. Yet, while you can take the girl out of Finance, you can't take the Finance out of the girl! If you have any questions, feel free to call/text me at (562) 972-0351, or visit me at www.AlissaAlvarez.com

Tags: compound interest, mortgage planning, simple interest