Sunday, March 17, 2013

Retirement: What is Compound Interest?

The joy of saving and investing for long periods of time is most exciting because of the concept of compound interest. And I'm not the first to think so. Even Benjamin Franklin was keen on compound interest!

Definition. According to, compound interest is interest which is calculation not only on the initial principal but also the accumulated interest of prior periods. For example, you initially invest $100, and earn 10% per year in interest. The interest in the first year is $10. In the second year, you actually have $110 invested, which again earns 10%. The interest for the second year is $11. This is a very simple example. Most investments do not currently pay 10% interest, nor do they only pay you once per year.

Calculator. I found a really good compound interest calculator that allows you to put in your specific particulars, including initial investment, additional investments, length of investment and interest rate. The calculator shows you the results as a final dollar figure, a graph, and a list of each years investments, interest and final value accumulated. When you use the calculator, I would highly suggest using the monthly compounding option as it is the most common. Of course, try all the different options to see the major difference in the frequency of compounding.

The opposite is true. This same interest calculation is done for money you borrow as well. You are probably most familiar with it in terms of the interest you may pay on your credit cards. This is why you hear about the high numbers of years it can take to pay off credit card balances. Those really high interest rates just keep adding to the balance and often your next payment doesn't even cover all of the interest you were just charged. It is a never ending cycle and very hard to get ahead.

Earn. My preference is to earn interest on our money, than to pay a dime of interest. We do pay interest on our mortgage, so I do know how it feels to pay for the luxury of borrowing. My advice is to pay as little interest as possible, so the money that you might be paying in interest can actually be saved. Saved to earn interest over time.

Currently, we only earn 0.90% interest on the money in our money market account. Do you have any money set aside now that you are earning interest on? What rate are you earning?

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