Understanding the Power of Compound Interest
What is compound interest?
Compound interest is the type of interest that is calculated on both the principal and the accrued interest on the principal. Unlike the simple interest whereby interest is calculated on the principal alone, while calculating interest using compound interest, you will need to first add the accrued interest with the principal before you apply the interest rate on the total amount (that is, principal and interest).
Personally, I like surfing internet. I will like to share what I stumbled upon this weekend. If you have been one of the people who keep wondering why the Americans debts profile keep rising, by the time you are done with this article, you will know the reason. Possibly, this will help you on how you manage your personal finance from hence forth.
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I was researching about the student loan debt statistics of Americans when I stumbled on College Debt, a website that gives up to date information about US college debts. It also provides information on auto loans and credit card debts. What I saw amazed me. While the auto loan stood around $750 billion, it is surprising that college loan was more than double this amount. To be precise, the college debt as at the time of writing this article was about $1.57 trillion. This is very huge indeed. Also, credit card debt was standing at $882.60 billion.
You may want to ask me, what is my problem about this? Well, it is not just about the debt figures. One thing that drew my attention was the fact that the student loan balance keeps increasing by approximately $2,800 every second. Initially, I was confused about this. Being a weekend, I asked myself if student loans are being approved every second. It didn’t take long time before I realized what was responsible for the steady rise in the debt profile. It is simply because of the compound interest.
Compound interest can either work against or for you. It depends on which side of the fence you are standing. If you are a borrower, your debt will keep rising if you don’t pay up the loan. This means that, as the clock keep ticking, your debt will continue to rise. On the other hand, if you are a lender, compound interest will be earning income for you on your capital, even when you are sleeping. This type of income is called passive income, as you don’t need to be physically involved before the money works for you.
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So, what does this mean to you? How is compound interest affecting your finance? This will be a question you need to answer by yourself. If your answer is not pleasant, you can start taking the right step from now. You need to work out strategy on how to quickly pay off your debt. As you are paying down the debt, the effect of the compound interest will be reducing. However, it is not enough for you to get out of debt, you should strive to be on the positive side of the equation. This is the investing side. By the time you work your way to the investing side, you will begin to enjoy the benefits of compound interest. Don’t forget that the interest rate on your debt or investment will equally determine the impact that the compound interest will have on your finance. The higher the interest rate, the higher the interest you will need to pay on your debt. If you are a lender, the higher the interest rate, the more income that compound interest will help you earn.