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What is Compound Interest and How Does it Work?

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Learn about compound interest and how it works.

Description: An illustration of a person holding a piggy bank, with a graph showing the growth of their investments over time thanks to compound interest.

Compound interest is a form of interest calculated using the principal amount of a deposit or loan plus previously accrued interest. Simply put, Compound interest is the phenomenon of earning interest on interest. For instance, let's say you make an initial deposit of $1,000. The interest rate is 1% per year. After the first year, you will earn 1% of the initial deposit, or $10.

In the second year, the interest is calculated on the original principal amount as well as the accrued interest from the first year. This means that instead of earning $10, you will now earn $10.10 - the 1% of the initial deposit plus the additional 0.10% of the accrued interest. This is Compound interest.

Compound interest has been a subject of debate in recent years. For example, in a lawsuit between two parties, one party alleged that the other had failed to pay interest on a loan at a rate of 9% per annum. But the parties dispute whether the interest rate was simple or compound. The trial court determined that there was no genuine issue of material fact as to whether the loan agreement provided for compound or simple interest.

Compound interest can be a great way to earn more money over time. Currently, the best interest rate on CDs (certificates of deposit) are around 2% annually. But this doesn't tell you the full story of the money you'll earn with a CD because it takes into account Compound interest.

If you want to maximize your returns, you should take advantage of Compound interest. By keeping your savings in a low interest checking or savings account, you're missing out on Compound interest — which is your money growing on itself.

The same goes for mortgages and refinancing. While interest rate on mortgages and refinancing have increased in recent months, they are still low compared to other types of investments. This means that you can still reap the rewards of Compound interest if you're willing to invest in a mortgage or refinance.

Compound interest is interest calculated on the initial principal and the accumulated interest from previous periods. The more frequently the interest is compounded, the higher the amount of interest you will earn. For example, if you have a savings account that compounds your interest quarterly, you will earn more interest than an account that only compounds your interest annually.

Compound interest can work against you as well. Credit cards often charge high interest rate as well as Compound interest. This means that if you're carrying a balance on your credit card, the interest you owe could grow significantly over time.

Money market accounts are a great way to take advantage of Compound interest. Money market accounts combine the best features of savings and checking accounts, rolling great interest rate with easy access to your funds. This means that you can earn more interest, but still have access to your money when you need it.

Compound interest can be a great tool for invest and savers alike. As long as you understand the risks and rewards of Compound interest, you can make wise investments and maximize your returns.

compound interestinterestprincipaldepositloanaccrued interestcds (certificates of deposit)checking or savings accountmortgages and refinancingcredit cardsmoney market accounts

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