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How can compound interest help me – or hurt me?

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Have you heard of compound interest? Do you understand how it works? It may be one of the most important things to know if you want to use money wisely.
 
What is compound interest?

Let’s say you put $1,000 in a savings account. Your money gets 3% interest. After one year, you will make $30 in interest. And, you will still have your original $1,000, for a total of $1,030. During the second year, you are now making interest on $1,030 – your original deposit and the interest from year one.

In other words, you are earning interest on your interest. That’s called compound interest. And it can have a big affect on how fast your money grows over a long period of time. In fact, if you invested $1,000 and earned 6% interest every year, your money would double in 12 years!

 
Tip: There is a simple formula you can use to see how fast your money will grow. It’s called the “Rule of 72.” Here’s how it works:
 
You just take the interest rate your money is earning, and divide it into 72. That’s how long it will take for your money to double. For example, 6 divided into 72 is 12. So with 6% interest, your money would double in 12 years. If you made 12% interest, your money would double in 6 years.
 

Compound interest can help you when you are investing and saving for the future. But it can also hurt you when you are borrowing money.

How can compound interest hurt me?

 

Compound interest works for you when you are getting interest on your savings. It works against you when you are paying interest on debt. Here’s an example:

 
Let’s say you get your credit card bill. You can only make the smallest payment you are allowed. This payment is called the minimum payment. Why is this a problem?
 
Credit cards charge high interest. If you only pay the minimum, a lot of those dollars will go to pay off the interest you owe. Very little money may go to pay back the money you borrowed. Next month, the same thing will happen again. You’ll keep paying a lot of interest. And it may take many months – or even years – before you pay of your debt.
 
That’s why you should avoid going into debt. And, if you have to borrow, pay off the debt as quickly as possible.
 
Try this: the Bankrate.com web site has a calculator that shows you how much extra you can pay on a credit card debt if you only make the minimum payment. Calculate now. 

 
Tip: Paying off credit cards in full every month is the smartest way to use credit. But what if you have had some financial trouble and can’t pay your card in full? Pay as much as you can every month. If you pay only the minimum monthly payment, it could take years to pay off the debt. Any amount you can afford above the minimum will dramatically reduce the time it takes to pay your card off.
 



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Here are some related link(s):
[1] How does compounding make my money grow faster? – Investor Education Fund This web site explains how compounding makes money grow quickly.
[2] Cost of Borrowing Calculator – Industry Canada  This calculator shows how the costs of borrowing can really add up.

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