Compound interest is like a snowball rolling down a hill. At first, the snowball is small and doesn’t seem to be growing very much. But the more time that it rolls through the snow, the bigger it gets until its growth is undeniable. The momentum keeps it growing.
The snowball effect of compound interest can be a boon or a burden, depending on the circumstance.
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Compound Interest and Savings
Compound interest is the concept that your account’s interest rate breeds more interest. Essentially, as your interest rate helps an account balance grow larger, the more growth you’ll reap from it.
Compound interest can be a real boon when it comes to your personal savings. It will help the balance inside your savings account grow faster than if you left it in an account without an interest rate — or at least, an interest rate that is so low that you wouldn’t notice the effects of compound interest.
You can reach your savings goals sooner and minimize your risks of living without a safety net, like an emergency fund. If you’re living without a substantial emergency fund, you might not have an easy method to pay for an urgent expense that falls into your lap. You might have to consider an online borrowing option like a personal loan to help you recover from the problem as soon as possible. There are some important questions to ask when borrowing before you fill out any loan applications. You’ll want to make an informed decision in an emergency.
You can avoid this situation by building an emergency fund and capitalizing on compound interest.
How Can You Capitalize on Compound Interest?
Find a High Interest Rate
Invest in a savings account with a higher interest rate, such as a high yield savings account or a money market account. These accounts typically have annual percentage yields of 2-4%, which is much higher than a basic savings account.
Online-only banks typically offer better deals when it comes to interest rates since they have lower overhead costs than traditional banks.
Make Regular Contributions
Consistency is key. The more you contribute, the higher your balance will grow. The higher your balance grows, the more compounding interest there will be. Automate contributions to your savings account every month to guarantee that your savings balance builds up.
Compound Interest and Debt
While compound interest is a boon for savings, it can be a burden when it comes to credit accounts. Outstanding balances on your credit accounts will grow with interest when you don’t pay them down. That interest compounds and makes the balances grow bigger and faster with every billing cycle that you pass. Again—imagine the snowball collecting more snow as it speeds down the hill.
Over time, your credit account balances could become too difficult to pay down in a reasonable time or manner. You’ll become more at risk of maxing out your accounts, defaulting on your payments and saddling yourself with a lot of debt.
How Can You Tackle Compound Interest?
Make Regular Contributions
Just like with your savings account, consistency is key. Make contributions to your credit accounts when the bills are due. Do not miss the deadlines. If you want to make payments easier, you can automate them through your bank account.
Pay More Than the Minimum
The minimum payment is the lowest amount that you can pay on a credit card bill. Paying the minimum is an effective way to avoid late fees, but it is not a good way to whittle down the outstanding balance and keep up with compounding interest.
Reserve Credit for Emergencies
Try not to use credit tools like personal loans for non-emergency expenses, like clothes shopping. Only use them when it’s absolutely necessary. This should keep your outstanding balances lower.
Compounding interest is neither a good thing nor a bad thing. It can help or hurt your finances, depending on the circumstances.