If you hope to grow your wealth, leveraging compound interest — which Einstein reportedly once called "the most powerful force in the universe" — is the way to do it. But while compounding can turn a relatively small amount of money into a fortune over the course of many years, it can also work against you if you're not careful.
Fortunately, if you know what to watch out for, you can avoid getting crushed by compounding — and instead, harness its power.
Compound interest is the interest you earn on your money, plus the interest that money has already accrued. In effect, it can supercharge your savings or investment accounts, making it easier to save for your children's education or for retirement.
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If you have a positive balance in a bank account, the interest you earn works for you. If you're in debt, however, the compounding effect works in the lender's favor.
Compounding interest can increase how much you owe, and make it harder to pay down balances.
That's especially true if you have high-interest debt, like a credit card balance. As of the first week of February, average credit card interest rates in the U.S. are more than 17%, according to CreditCards.com.
"It can easily get away from you when you have extremely high interest rates on credit cards, payday loans, personal loans," says Riley Adams, a Bay Area-based CPA who runs the financial website Young and the Invested. "If you're paying 30% annualized interest on a credit card balance and you don't pay it off in full, that amount that is still outstanding compounds."
Compounding can make getting out of debt even tougher. The trick to keeping yourself from falling deeper into the debt trap, experts say, is to assess your budget to make sure you're not paying off one balance while racking up a new one.
"Credit cards, pound for pound, are going to be the most detrimental because of the high interest rates," says Justin Halverson, a Minnesota-based financial advisor.
Aim to pay off your credit card balances in full each month or at least put as much money as possible toward that debt when payments are due. Every little bit helps: Even an extra $25 per month can help you reduce the effect of compounding and pay down balances faster.
You can use Grow's compound interest calculator to see how much of an impact compounding can have on your finances.
While compounding can help you build wealth over the long haul, Halverson says consumers should keep the other side of the story in mind, too. "It can be one of the biggest stumbling blocks if you have too much debt," he says.
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