What is Compound Interest?

Compound interest is brutal to say the least. Compound interest can make a 10% interest have a triple or quadruple payback over the course of however many years. A $500,000 mortgage loan can wind up having a payback of $2 million over the course of a conventional mortgage. Over the span of 30 years, lenders are making a tremendous amount of money from interest. But why? This occurs due to the power of compounding interest.

How Does Compound Interest Work?

Compound interest is the process of interest rates multiplying unto themselves. In lament’s terms this refers to interest earned on already accrued interest. If you earned $10,000 in interest in year 1 of your investment and you have a 10% effective interest rate, by year 2 you'll earn $11,000 in interest. By year 3 you'll have earned approximately $12,100 in interest payments. The interests compounds on itself eventually increasing exponentially.

Compounding over the Years

Compound interest can be so potent because over the years it really begins to show its power as the effect of multiplication take root. Over the course of a 30-year mortgage, compounding interest becomes very costly.

Daily Compounded Credit Card Interest Rate

Credit card interest rates are actually compounded daily! Now over the course of days or weeks, the impact may seem negligible but as balances grow the effect can be profound. Over the course of years compounding interest really becomes noticeable. This holds true for both long term loans and long-term investments.

Who's Compound Interest Good for?

Compound interest is great for investors but bad for borrowers. The borrowers that pay compound interest end up paying back much more than they borrowed. Investors or invest with compound interest end up receiving much more than they initially lent.

Everything is relative at the end of the day, but if you're borrowing money the cost really tends to eat into your principal payments. This is why it's important to try and pre-pay whenever possible.