Saving up? You should understand compound interest.
POSTED ON July 15, 2019
The good thing about saving and investing is compound interest.
When you lend your money, you temporarily lose the chance of using it. This is called opportunity cost. The borrower now pays this cost back through interest. So, interest is basically the cost of borrowing money.
The same logic works with savings accounts. The bank is paying you to leave your money with them. But instead of paying you the interest, they just put it on top of the money you left with them. This is where compound interest starts.
The interest you gain is already yours. But if you don’t withdraw that money, you are letting the bank borrow it on top of what is already in your account. So, the next time the bank pays you interest, it gives you back the money you deposited plus interest you have not withdrawn. This becomes a cycle and that’s how compound interest happens. It’s a virtuous cycle.
How to make compound interest work for you
Besides saving money, you can benefit from compound interest when you invest. For example, if you have a time deposit that matures and you reinvest everything in another time deposit, you’re compounding it.
Reinvesting is the key. This means instead of spending what you earn from your investments, you let your money grow. So, every time your investments grow, you have more to invest with. Again, it’s a virtuous cycle.
For investments like time deposits, it’s straightforward: just reinvest every time they mature. For bonds, you can reinvest the coupons. Then, if the coupons you reinvested in other investments mature together with the bond itself, you can take everything and invest it all again.
It’s a virtuous cycle.