When you see money as your slave that can be sent on money-making errands, thats when you start to enjoy the fruits of your hard-earned funds.
Knowing fully well that your slaves (Interests) could also serve as your money-making slave is another level of investment savviness.
Getting interest from your capital is interesting. Getting additional interest from the initial interest on your capital is sweet in the pudding.
This article will help you understand this concept in simple terms without the unnecessary ambiguities of financial terminologies.
Compound Interest in Simple Term
The ability of your money to make you money and that money to make you extra money is Compound Interest.
It is simply reinvesting the addition of your initial capital and the interest generated on it over a period. This new addition is referred to as your new principal at the point of reinvesting.
The reinvested capital also generates interest. And the process of adding and reinvesting is repeated.
The repetition is known as the compounding frequency.
When interest generates extra interest for you, that is compound interest.
Simple Interest VS Compound Interest
A lot of people are accustomed to simple interests. Simple interest calculation is the cost of borrowing or lending money.
If you are borrowing a loan, you owe the interest. If you are investing, you earn it.
That said, unlike compound interest, simple interest does not have any compounding effect. You only get paid your principal plus the interest agreed at maturity of the investment.
In general terms, Compound Interest is a better and faster way to grow capital and build wealth.
In the same vein, loans calculated in compound interest can be detrimental to you as a borrower. As the interest compounds, your debt increases.
It is one of the reasons why personal finance savvy people like you will always prefer their investment to have compound interest. And their loans are better off at simple interest calculations.
Core Variables
Dear investors, compound interests are not a stand-alone principle. Some factors and concepts play relevant roles in compounding.
- Initial Capital: What is the amount you are starting with? Or how many loans are you accessing? Compounding is based on the initial capital you invest or borrow as the case may be.
- Interest Rate: The higher the rates, the more funds you earn.
- Tenor: Compounding is a long-term strategy. The longer the tenor, the more it compounds and this relates to your earnings over that period.
- Compounding Frequency: Interest compounds annually, bi-annually, quarterly, monthly, or daily. The more frequent the compounding, the more you earn.
How to Use Compound Interest To Your Advantage
If you have been following the content to this point, you must have realized how simple the concept is.
As simple as it sounds, it can make or mar your wealth-building strategy if you are not aware of how to apply it.
To take full advantage of compounding, you have to invest early. As this helps increase your tenor (time horizon).
You must be very detailed about borrowing loans. It is key to steer clear of loans whose interest compounds. One of such is a credit card.
While navigating your investment options, be open to discussions around rates and compounding frequencies. These are going to work to your advantage in the long run.
Conclusion
When Albert Einstein called compounding interest the eight wonders of the world, he was sure of what he was saying.
Highly successful investors have used this concept to build wealth over time.
It is your turn to do the same.
