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What is Compound Interest?

compound interest

Compound interest simple means that interest is paid upon interest – On the one hand, if you have savings, it is great as you are earning money, but if you have credit cards or other debts, then any compound interest added means that it is costing you money.

To explain:

Compound interest on savings

If you opened a savings account with £1000 that paid 10% AER (Annual Equivalent Rate), then at the end of year one, with the money untouched, you would have £1100 in savings which includes the £100 of interest earned.

At the end of year 2, you would then earn £110 in interest which is 10% of the original amount saved plus 10% of the 1st years interest, so the amount in your account would now be £1100 plus £110 interest = £1210 in savings.

In the case of savings, compound interest can be extremely powerful, as leaving money untouched in an interest bearing account can help grow a small amount quite significantly over time, without even adding any further funds.

Compound interest on credit cards

When you make repayments on a credit card you are not only paying back the interest on the original debt, but also on the interest that is added. In the same way that savings can grow over time without adding to the original sum, debt can also grow without you spending any further. So now with compound interest your debt is costing you more.

This is why before taking on any debt, it is important to understand the interest rate calculation. As with any type of borrowing, from credit cards to mortgages, it would be more prudent to pay it off as quickly as possible, as over time, in the case of debt, compound interest is not your friend.

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