September 12, 2024

If you have a credit card or a savings account, you’ve experienced compound interest. It’s when an account accrues interest on the principal amount plus any interest accrued over time. It can either work against you, like with loans or lines of credit, or for you, with investment accounts.

Compound interest can make paying down debt feel like an uphill battle or help your money grow steadily over time. Here’s how:

• If you’re paying interest on debts like credit cards, student loans, or a car loan, allowing balances to accrue over time rather than paying them off will cost you more in interest charges over time.
• If you’re earning interest  on something like a high-yield savings account, compound interest can work in your favor. Over time, you can meet your savings goals with help from the power of compounding.

Debt: When compounding interest isn’t your friend

When you take out any kind of loan, the lender charges you interest on the amount you borrowed — your “principal” amount. If you don’t pay off the debt right away, compounding interest charges are added to your principal.

Credit cards are a good example. Credit cards use revolving credit, which means that you get a maximum amount to spend, and you can keep borrowing that money as long as you repay what you owe (either payment in full or the minimum payment each month).

Say you have a $1,000 balance on a credit card at an annual percentage rate (APR) of 20%. That’s roughly 1.67% interest accrued monthly, which means your balance after one month would be $1,016.70. If you only made the minimum payment (which we’ll say is 2% of your balance) on your due date, you’d pay $20.33 toward the debt, bringing your balance down to $996.37.

While making just the minimum payment keeps your account current, you end up paying more in interest over time. In the above scenario, your balance would be $978.28 after six months of making minimum payments, meaning only $21.72 went toward the principal during that time.

Missing your monthly payment is a big deal. You could start owing more interest that adds up, your debt could go to a collection agency, or, if you have a secured debt, you could have the secured property — like your car or home — seized. All these things can have a huge impact on your credit and your life.

Saving and investing: When compound interest works for you

Compound interest can work to your benefit, too. Let’s take that same $1,000 and assume you put it into a savings account: This time, instead of paying interest, you’re earning it.

Remember, your balance and the earned interest get compounded. Every year, if you don’t take money out, you’ll have a higher account balance. As such, you’ll also earn more interest on that higher balance. You’re now earning interest on your interest.

As you can see, by leaving your savings in the bank, your balance can grow because of compounding interest. If you make it a habit to deposit more money into this savings account each month, compound interest can earn you even more. Check out what happens when you start with $1,000, but also add $500 each month:

How to keep compound interest working for you

In short, time is the key factor. The longer you take to pay down debt, the more interest you’ll compound and have to pay. However, if you have savings and investment accounts, time works in your favor. The longer you keep money in your account, the more time you have for compound interest to grow for you.

• If you have debt: The longer you take to pay down debt, the more interest you’ll compound and have to pay. However, if you have savings and investment accounts, time works in your favor. The longer you keep money in your account, the more time you have for compound interest to grow for you.
• If you have savings: Consider putting away money as early as you can. If you start saving for a house or retirement in your 20s, your money can compound and earn significantly more interest than the account of a person who starts saving or investing in their 40s. More time to save and invest gives you the opportunity to earn more compound interest.

A strategy that may help you lower interest paid on your loans and boost interest earned on your savings is to sign up with your bank for automatic payments and deposits. That way, you can help avoid the consequences of missing a loan payment and deposit money in your savings accounts.