What is compounding, and how does it work?


You’ve probably heard the word “compounding” before, but do you really understand how it works? If not, you’re in good company. In a FINRA Foundation financial literacy study, just one-third of Americans could accurately answer a question about compounding interest payments. Yet understanding this concept is key to making sure your money habits work for, and not against, you.

Take investing for retirement, for example. Compounding interest is the reason why we benefit from starting as soon as possible: Your early investments generate interest, resulting in a higher investment for the next interest period. This cycle continues so that the interest you’re earning is continuously calculated based on a new, higher amount (as it includes interest already earned).

So compounding is a good thing?

When it comes to your savings and investments, definitely. Savings accounts work on the compounding interest model, too, but current rates are much lower than you can reasonably expect from the stock market.

But compounding can work against you, too: If you carry credit card debt from month to month, you aren’t just charged interest on your most recent purchases. You’re also paying interest on the interest charged from previous months. And that can add up fast.

Say you owe $3,000 on a credit card with an 18% annual interest rate. That means each month, your card’s balance accumulates 1.5% interest. Because interest on credit cards is calculated daily (as opposed to weekly, monthly or annually), you’re charged about .05% each day for that balance.

If you skipped a payment in January, for instance, your interest in February will be determined based on the higher amount of $3,045. Even if you don’t skip payments but pay only the $100 minimum each month, it’ll take you almost three and a half years to pay off the balance — and you’ll fork over an extra $1,000 in interest.

What should I do with this information?

Remember that compounding interest is a beautiful thing for investors, which should encourage you to invest as much as possible, so you can see your money multiply over time.

And look for ways to mitigate the negative impacts of compounding interest on your debt. Negotiating with your lender to lower your interest rate, paying more than the minimum or, better yet, paying your credit card bill in full every month are the best ways to do that.

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