Compounding Interest Can Make You Very Rich Or Very Poor
The term compound interest was referred to as the “greatest mathematical discovery of all time” by Albert Einstein. In simple terms compound interest means any interest charges that are added to the principal (the initial amount you borrowed or invested). There are two main types of compound interest. There is the kind that can help you for example if you own stock that pays dividends or invested in a CD (certificate of deposit). On the other hand there is the kind that can hurt you for example if you carry a balance on your credit card bill you are most likely being charged a huge interest rate.
Let’s start out with a simple example. Say you have $100 balance on your credit card bill and you are charged 10% interest every month. To calculate this it’s just $100 x 10% = $10. So you are being charged $10 a month in interest and now your total balance is $110. A month has passed and now it’s month number two and your credit card balance is $110 because you didn’t pay off your credit card bill last month. Using our formula again and the same interest rate your new balance will be ($110 x %10) $121. Over two months your credit card bill has increased 21%. Imagine if you carried more than a balance of $100 in this example!
To get your compound interest rate you need to know your APR (Annual Percentage Rate) on your credit card. Usually the APR is the approximate interest rate you might pay over the year. Most credit card companies compound interest on a daily basis. If you have a balance of $5,000 and a 20% APR (about 0.055% as a daily rate) your balance on day 2 of the month would be $5,002.73 then on day 3 it would be $5,005.48. This can add up quick! Most credit cards give you a grace period of 30 days so as long as you pay off your bill each month you aren’t charged any interest.
You can use the power of compound interest when you invest your money. When investing in a CD or high interest savings account you want to find the highest rate possible. Rates over the last few years have been extremely low between 1-2% in this type of investment. So if you find a CD offering a 2% yearly interest rate over 5 years you can earn $5,520 vs if you found a 1% interest rate int the time frame you would only make $5,255 (this is your $5,000 + $255 earned in compound interest). Unfortunately there is no simple risk free investment vehicle that will offer you the interest rate your credit card company is charging.
If you use the power of the stock market and dividend paying stocks you can earn a lot more money than just 2% a year. Let’s use the dividend paying stock General Electric (GE) as an example. Right now GE offers a dividend of $0.92 per share payout or roughly a 3.8% yield (this is based off of share price). These dividends are usually paid quarterly. If I purchased 100 shares of GE at $23 a share my initial investment is $2300. Then I get paid about ($0.92/4=$0.23) per share per quarter. If GE stock stays right at $23 per share my investment is now worth $2323 after one quarter. When you set up an investment account with a brokerage you can either have them reinvest your dividends right back into your stock or just have them pay you cash. So you can elect to earn $23 in cash or have another share of GE purchased. This all depends if your brokerage buys fractional shares as well. If you reinvest your dividends you now have 101 shares of GE and when the next quarter ends you will get a payout of $23.23 which you can use to buy another share of GE so now you have 102 shares. You can see the effects of the returns from the chart below (assuming GE stays $23 a share).
By the time 5 years are up you own 22 more shares than you started with and are $806 richer. Plus you will earn all capital gains as GE stock increased in value. Now imagine doing this for 30 years! To figure that out you can use a compound interest calculator or use the formula A=P(1+r/n)^nt.
A=Amount of money accumulated after n years including interest
P= principal amount (the initial amount you borrow or deposit)
r=annual interest rate
n=number of times the interested is compounded per year
t=number of years the amount is deposited or borrowed for
If you invest in the S&P 500 which earns on average around 8% per year using the initial $2,300 investment you would earn $23,144 at the end of 30 years. The key takeaway here is time is your friend when using compound interest. The longer the time period the better return you are going to get.
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About Shaun Archer Tatum Shaun works in corporate finance in New York City. He has done financial consulting for several start-ups and has worked at several Fortune 500 companies. He has contributed several finance/investing articles on Seeking Alpha which have been published on Yahoo! Finance.