What Is Compounding Interest? 

Any online search for ‘compounding interest’ is likely to return complicated formulas and so-called easy explanations of the term, which are anything but…! The following is a truly simple guide as to exactly what compounding interest is and how it affects any of your borrowing or investments.

The Easy Guide to Compounding Interest

• Explaining compounding interest
• Simple interest vs. compound interest

Explaining compounding interest

Before we get down to the nitty-gritty of what compounding interest is, let’s first determine the definition of interest and how it’s displayed. 

Interest is the cost of borrowing money or, when it comes to savings and investments, the level that you’ll earn from placing your funds into a financial institution, such as a bank, bonds, or stocks.

Once we understand this, we can move on to discussing the two different ways that interest is presented: namely, simple interest and compound interest.

Simple interest vs. compound interest

The easiest way to understand the difference between the two is this:

• Simple interest is based on the principal amount of the loan or investment. For instance, you borrow $1,000 and pay a fixed percentage of this over a specified number of years for the benefit of having the money to use. 
• Compounding interest takes more into account. It too is based on the principal amount (or our example of $1,000) plus the interest that this accrues on this amount over a defined period. In other words, you also pay interest on the interest, as well as that on the amount of the principal loan.

When we talk about ‘the period’ in compound interest, this can be defined as frequent or infrequent. The former might be as often as daily, weekly, or monthly. Infrequently could mean every quarter, year, or biannually.

For borrowers, you’ll end up paying less overall with a simple interest rate. Conversely, this means that those who’re investing will see their money grow faster with compounding interest rates. Investors who’re looking to earn as much as possible from their stake—for instance, when saving for retirement­­—then looking for options with frequently compounding interest is the most advantageous.

One example of when compounding interest doesn’t work in your favor is with credit cards. These typically compound interest daily. If, for example, you have a credit card interest rate of 18%, this equates to a daily interest rate of 0.0494%. If you fail to pay off the balance in a timely manner, this can lead to spiraling debt. Such a scenario would see a $5,000 balance increase to $5,002.47 after one day, and to $5,004.94 after two. Fast forward a week, month, or year, and the total owed becomes rather hard to swallow.

The takeaway from this is that compounding interest is good for investors and savers but bad for borrowers. Plus, to build a significant wealth to fund your retirement you should be seeking out compound earnings, such as stocks, that will see your assets increase at the fastest rate. This is also effectively achieved through dividend reinvestment and automatically purchasing more of a company’s shares each time a dividend payment is achieved. 

Bamboozled by Compounding Interest & Financial Choices. Let Capita Take the Strain 

Making the best financial choices needn’t have you tearing your hair out. The experts at Capita have long been creating financial security for their clients through wise investment and saving options. That’s why so many people trust Capita to advise with all their financial choices, from pensions and stocks to help with healthcare choices, loans, mortgages, and every other facet of life’s financial jungle. 

Head across to https://www.capitafinancialnetwork.com to find out more and get in touch for a confidential chat about your requirements.