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12/5/07

Explaining Compound Interest

Compound interest is a great financial tool that can help you achieve a good chunk of wealth. There are many financial calculators that show you how compound interest can help grow an investment. The only thing you need to be aware of is that if you are relying solely on compound interest as you return on investment, you should be focusing only on the long term return. Usually, people use compound interest as their return on investment for investments such as individual retirement accounts (IRAs) and savings accounts.

Simple interest is calculated using a simple formula: Principal x Interest Rate x Time. So, for example, let us say that you deposit $1,000.00 in an account for one year that yields a 4% interest rate. Therefore, your return for the year would equal $1,000.00 X 4% or .04 X 1. This equals $40. Therefore, at the end of the year, your account balance would be $1,040.

If you wanted to figure out how much interest you would make per month, the formula is the same (Principal x Rate x Time), however, your “time” would change from 1 to 1/12. Since there are 12 months in a year and you want to figure out the return per month, you would use 1/12. Therefore, your equation would be $1,000.00 x .04 x 1/12. This equals about $3.33 per month.

Under simple interest, after 1 month, your principal investment of $1,000.00 would now be $1,003.33. Even though your principal increases, under simple interest, you would still calculate the interest based upon the original $1,000 investment. Compound interest is different in that you return increases as your principal increase. Therefore, after the first month, instead of calculating the interest on a principal amount of $1,000, you would calculate interest on the new principal amount of $1,003.33. Therefore, under simple interest, in month 2, you would have $1,006.66 in you account. However, under a compound interest account, you would have $1,006.67. I know that one cent is basically nothing, however, that is why compound interest is a long term investment. At the end of one year, under simple interest, your account balance would be $1040, however, under compound interest, your account balance would be $1040.69.

As you may notice, you get about $0.69 more under a compound interest scheme. Over the years, this number adds up significantly. In fact, the difference could be thousands of dollars. The point is, use compound interest as a safe, guaranteed, long term return on investment.


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