The Importance of Understanding Compound Interest (With Random Financial Methods Notes)

by Matt B

$2000 at 5% interest with NO CONTRIBUTIONS

$2000 at 5% interest with NO CONTRIBUTIONS

Interest is a pretty simple thing to understand.  If you have a deposit account that earns interest, the bank pays you a predetermined amount of interest so they can use your money to loan to other customers.  Conversely, if you have a credit card or loan, you pay interest to the bank for this borrowed money.  Because this is such a simple concept, few people will have trouble explaining it to someone else if needed.

But what, exactly is Compound Interest?

If you understand it, compound interest is also pretty simple. Simply put, compound interest is money earned on prior interest payments along with the previous balance.  It is actually easier to illustrate.  Let’s say you have a savings account with $1000 at a 2% interest rate.  If this account compounds monthly, (many do) at the end of the first year you will have earned $20 in interest.  Now, you are earning 2% on $1020 instead of $1000.

Why is it important to understand?

If you understand compound interest and how it works, you will maximize your payments on interest bearing accounts. Most accounts compound relatively frequently, and it can make your balances grow very quickly, especially if you are earning a decent interest rate.

I realize that this is a relatively short post, but I hate to leave you with nothing to read on a boring weekday at work. This is pretty simple, straight forward and boring…and I completely realize that. It has been a busy week for me, as I am preparing for vacation next week, and I accepted a new job this week. (More to come on this development, although it is not a very big deal.)

I may actually double-post today just to tide you over, and of course I will have my weekly roundup from the best blog posts of the week tomorrow. I am also throwing a new twist into my weekly links, so be sure to check it out…it will be interesting.

{ 2 comments… read them below or add one }

phillipmiller October 11, 2012 at 9:41 pm

Great job for its really nice because today is my exam on Mathematics Of Finance.

David Williams October 17, 2012 at 8:41 am

Can you tell me about this (Â Now, you are earning 2% on $1020 instead of $1000.) i am little bit confused .
Thanks

Leave a Comment

Previous post:

Next post: