Wednesday, July 11, 2012

Understanding The Power Of Compound Interest

According to Wikipedia:

Compound interest arises when interest is added to the principal, so that, from that moment on, the interest that has been added also earns interest. This addition of interest to the principal is called compounding. A bank account, for example, may have its interest compounded every year: in this case, an account with ¤1000 initial principal and 20% interest per year would have a balance of ¤1200 at the end of the first year, ¤1440 at the end of the second year, and so on.

In order to define an interest rate fully, and enable one to compare it with other interest rates, the interest rate and the compounding frequency must be disclosed. Since most people prefer to think of rates as a yearly percentage, many governments require financial institutions to disclose the equivalent yearly compounded interest rate on deposits or advances. For instance, the yearly rate for a loan with 1% interest per month is approximately 12.68% per annum (1.0112 − 1). This equivalent yearly rate may be referred to as annual percentage rate (APR), annual equivalent rate (AER), annual percentage yield, effective interest rate,effective annual rate, and by other terms. When a fee is charged up front to obtain a loan, APR usually counts that cost as well as the compound interest in converting to the equivalent rate. These government requirements assist consumers to compare the actual costs of borrowing more easily.

I do not intend to under estimate people but not all people can grasp this definition of compound interest easily unless you show them how this is applicable to their daily lives no matter how the terms are simplified.

Compound interest in simple term means your money plus interest earned thru bank savings earns another interest. Now let us go through the illustration below.

I need not to ask but I am sure you are looking at the obvious. It is like a planting a tree and having fruits after another after another.

So what does this want to show us? That by savings and eventually investing our hard-earned money into various investment options available, we get our money work for us instead of the other way around.

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