how does compound interest work.
In: Economics
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 $750,000 by the time you pay it off.
You get interests on the interests you made.
For example :
You place 100$ 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.
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