You get interests on the interests you made.
For example :
You place 100$ in an account at a really good rate of 100%. By the end of the year your account should have 200$ in it, meaning you made 100$ interests.
The thing is, your account is now 200$, not 100$ anymore. So if you keep this account at 100% for another year, your new balance at the end of year 2 will not be 300$ (100$ interests) but 400$!! Because 100% of 200$ is 200$.
That means, during year 2 you made 2 seperate types of gains :
1) 100$ on what you invested (wich is called interest)
2) 100$ on your gains/interests of year 1(wich is called compound interest)
Compound interest on your personnal investments work the exact same way on smaller interests rates.
It’s important to realize that compounding interest can work against you just as easily…
All these examples are “You invest $100… you make $110” and so on.
Compounding interest is also what makes paying debt, specifically credit cards (18%), mortgages (~3-4%),and student loans) so difficult. Imagine you borrow $100, and pay back a share of it. But now, the $100 you borrowed is actually $118. And the next year it’s up to $139. If you didn’t pay back a substantial amount, the interest is going to be more than you pay back. And then next month/year, all you’re able to do is cover the interest.
A real life example – if you get a mortgage over 25 years, you’re paying MOSTLY interest for the first 10-12 years of your payments. Your principal (the amount you borrowed) is barely affected because the interest is so high (based on a 25 year payment plan). If you borrow, $500,000 – the compounding 3% interest will make that closer to $750,000 by the time you pay it off.
Let’s look at both simple and compound interest.
Simple: the increase in percent is relative to the initial amount. So the interest added will always the same amount.
While in compound the interest is a percent of the the initial amount + the interest added so far. So the new intrest added is always increasing!
ELI3: Let me hold some money for a while and you will get extra, then later extra **of the extra too**!
ELI5: Simple interest = a bit of what you gave me. Compound interest = a bit of what you gave me and a bit of that bit. For example: Let’s use 10% a month interest. Let me hold your $10 (so I can use it) and a month later if you want it back I’ll give you $11. If I get to hold it another month it’ll go up not by $1 to $12 but by even more! If you want it back then you can get $12.10. After 1 year you’ll have $31.38. The magic really increases over time, so that in 10 years you’ll have **$927,090.69**!
Compound interest is when you include the interest earned to the principle (initial money put in) when calculating future interest.
It’s a bit easier to understand with an example: say you put $100 in a bank account earning 20% interest, annually. After your first year you would have $120 ($100 x 1.2). Assuming you don’t take or add any money, after your second year you would then have $144 ($120 x 1.2)
You earn interest on the initial amount, but also on the previous period’s interest.
say you have $100 that gets 10% interest annually. At end of the year, you have $110 — $100+$10 interest. The next year, you’d earn the 10% on that $110, not just on the initial $100, so you earn $11 in interest.While it’s just a little difference early on, as the years go it, it starts to get much larger.
I have $10. I invest $10 in an investment that will get me $11 back every month, or a 1% return.
However, if I just keep that $10 in the same investment I will get way more than that 1% return over time if I take the profits from the investment and invest that as well.
The first month I invest $10, I get back $11 for a profit of $1
The second month I invest $11 and get back $12.1 for a profit of $1.1
The third month I invest $12.1 and get back 13.31 for a profit of $1.21
Fast forward 10 years, and that $10 has become $27.07.
You have $100 that you deposit the bank at 5% interest. At the end of the month, the bank pays you $5 in interest. You now have $105.
If you leave the $105 in the bank for another month, you’ll earn more interest because you have more money. So instead of $5 in interest, you’ll get $5.25
Next month you’ll get another $5.76, and the interest keeps going up.
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