Compound interest explained.
Let’s look at the meaning of the term compound interest first,
and follow it up with numerical examples.
Interest is a fee paid for the use of someone else's money.
The verb “to compound” in a legal context means make something bad worse.
That’s what we’ll review in this video.
My advice is: compound interest is great to earn, at the same time do everything in your
power to avoid paying it.
Let’s talk about a common problem that a lot of people have: creditcard debt, and the
inability to keep up on creditcard payments.
In our example, the creditcard company charges you 20% interest per year
on the outstanding balance.
Do you know what the interest rate is that your creditcard company is charging you?
Better check straight after watching this video!
Let’s say you have an outstanding balance on your creditcard of $1000.
We cover simple interest first, and then compound interest.
With simple interest, you have the habit of always paying the interest charged, but you
are not paying down the principal amount.
The interest charge is shown in red in this graph, as it adds to your debt.
As you always pay the interest charged immediately (shown in green), your outstanding balance
at the end of the year is the same as at the start of the year.
Next year, you do the same.
Start off with $1000 outstanding balance, $200 interest charged, pay $200, end with
the same amount of outstanding debt.
This is what that looks like if you keep doing this for five years.
Every year $200 interest charged, $200 interest paid.
Over five years, you have actually paid 5 times $200 = $1000 in simple interest, the
same as the original debt balance you start with.
If you thought that paying 20% simple interest was bad, then let’s look at what 20% compound
interest does!
Compound interest occurs when you have an outstanding debt balance, and have the interest
charged added to your outstanding debt balance.
20% interest on the opening debt balance of $1000 is $200,
so you end year 1 with $1200 in debt.
You start year 2 with $1200 in debt, and now get charged 20% interest
on $1200 which is $240.
$200 of this is interest on the original outstanding balance of $1000.
The other $40 is interest on interest.
Your outstanding balance is now $1440.
Add 20% interest on that.
And then 20% on that.
You now have an outstanding balance after 5 years of $2488.
In short, you have accumulated $1488 of interest on top of a debt that
originally was just $1000.
Here’s the same data summarized in a table.
Through the power of compound interest,
a $1000 problem has turned into a problem of $2488.
So what is the idea of compound interest?
Compound interest is interest on the outstanding debt balance, plus interest on interest, plus
interest on interest on interest, etcetera.
Obviously, if you are on the other side, and you invest $1000 at 20% annual compound return,
then this is a great thing to have.
Interest earned is now shown in green.
Your $1000 investment grows to $1200, then to $1440, to $1728, to $2074, and to $2488
after five years.
You have just earned in 5 years $1488 on your original $1000 investment.
My advice is: compound interest is great to earn, at the same time do everything in your
power to avoid paying it.
I hope you enjoyed this explanation of compound interest.
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