Albert Einstein once said “The most powerful force in the universe is compound interest.” I don’t know if I’d go that far but I will say that it can be your best friend or your worst enemy. It all depends on which side of the fence you’re on.
Once you understand it, you have a much better chance of getting on the right side of it.
Basically, if compound interest is working for you, you will earn interest on both your principal and interest. Then a snowball effect begins. Here’s an example.
Unfortunately, this can work in the other direction too. Credit cards are a prime example of how quickly this interest can become a crippling force.
Each month you’re charged interest on the amount you owe. The next month you are charged interest on amount you owe plus interest from the previous month. This goes on and on until the debt is paid in full. You sometimes end up paying back as much as twice or three times the amount you originally borrowed.
Two terms you regularly see when referring to interest are APR (annual percentage rate) and APY (annual percentage yield).
APR refers to the amount of interest you will earn or pay in a year without adding compound interest. Most credit cards advertise offers with the APR. This amount looks lower because it doesn’t factor in the additional interest.
APY is the amount of interest you will earn or pay in a year including compound interest. This number is a better indicator of how much you will actually be paying back on loans and credit cards.
Most banks will show the APY when advertising investment options like CD’s since this number is always higher.
The formulas used to figure APR and APY are somewhat complicated. For help, check out these calculators for mortgage, tax, credit card, investment, retirement and more. These calculators can also help you determine which bank accounts will pay the most interest overall.
For more information on the different types of bank accounts, head over to the Banking Information section.From Compound Interest to Banking Information