The origin of compound interest spans thousands of years; often attributed to the Old Babylonian period (2000-1600 BCE) due to their use of the translated phrase “interest on interest.” But some argue this fiscal marvel dates back to a place called Sumer, the southernmost region of ancient Mesopotamia in the Pre-Sargonic era (2600-2350 BCE). That is over 4,000 years ago!
What makes this interest so special? How has it survived to be the bedrock of loan and investment practices today? Let’s find out.
What is Interest?
To get a better understanding of compound interest, we should first look at the term interest and how it fits into our financial enterprise. Interest is the charge attributed to a person who has the privilege to borrow money from a bank, most often in the form of a loan. But interest also has another meaning, it is the amount of ownership that a stockholder has in a company/investment.
Interest accumulates rapidly, which can offer both beneficial or adversary consequences. One of the most difficult parts of repaying a loan is the interest that is added to the repayment terms. Also, one of the most steadfast ways money is made is through the interest that is added to an account.
The Difference Between Simple and Compound Interest
Now that we have a better understanding of interest, we can talk about the two main types: simple and compound. Simple interest refers to a set percentage that is applied to the principal amount in a given year. For example, you might invest $5,000 at 6% simple interest. This means that $600 will be added to your account each year without change.
Compound interest is most regularly communicated as “interest on interest” or “interest earning interest.” This principle allows the investor to gain more money as time goes on. If we go back to the first example, and you save $5,000 at 6% compound interest the first year will look the same as you will get $600 added to the account. In the subsequent years, your compound interest will be calculated on your new account balance, which in this case would be $5,600 and would continue to grow with time.
An interesting facet of compound interest is the rate at which the interest is eligible to be compounded. In the example above, we talked about compound interest on an annual scale, but these intervals are more often used on a quarterly or even monthly basis.
As financial planners, we love numbers! I’d like to give you the mathematical formula to calculate your projected compound interest on a given investment. If you would like, there is also a wonderful electronic calculator that you can use as well.
Why Is Compound Interest An Important Savings Tool?
Compound interest earns you money over time. This type of interest promotes long-term savings goals and has the power to make your savings grow faster than you might imagine. Since compound interest earns more money each time it is compounded, the longer that you are able to save (even if it is just in smaller amounts) the better chance you have to promote the growth of your wealth over time.
As you think more about long-term saving and the financial goals you set for yourself, consider that by saving at a more consistent rate for a longer period of time (with the benefits of compound interest) you can actually promote a higher overall monetary gain than if you saved a larger amount later in life. We always encourage our clients to save intentionally to meet the goals they have set, and compound interest is a wonderful perk associated with intentional saving.
A note of caution: compound interest can be a wonderful vehicle for saving and growing your investments, but it can also be a source of increased debt in the form of unpaid credit cards or loan repayments. Now that you know the value of compound interest, tread careful in the borrowing waters. Remember: I recommend you get out of debt as quickly as you can.
Remember – compound interest promotes the idea that time IN the market is more important than timING the market. You do not have to be a Wall Street hot-shot to be able to reap the rewards of compound interest. It is a savings and investment tool for every financially conscious person.