Interest is one of the most central parts of managing money, but while it may seem simple it’s often misunderstood.
Here’s a quick math problem. Don’t worry, it’s the only one and we’ll use round numbers. If you have $100 in a savings account that earns five percent interest a year, and you leave it in the bank for 10 years, how much money will you have when those 10 years are up?
Think you have the answer? Here’s a hint, it’s not $150.
The reason is interest compounds. When you put money in a savings account, you don’t only earn the interest on the initial investment. You also earn interest on the interest.
For example, look back at the $100 that’s earning five percent interest a year. After the first year, that $100 has earned $5 in interest and is now worth $105. So, the next year, rather than earning interest on $100, you earn it on $105. Five percent of $105 is $5.25.
This might seem pretty trivial when it takes three years to earn $.76, but over time the amount difference grows exponentially. By year 15, the account earns $10 in interest in a year, double what it did in the first year.
That’s the good news. The bad news is that compound interest also works on debt. Not just debt on loans you might take out to make a large purchase like a house, car or college tuition, but also on smaller debts. Things like unpaid electric bills, parking tickets and credit cards generally earn interest a lot faster than savings accounts or government bonds.
If you’re trying to save money, delaying payments on these things is only going to get in your way. It’s better to try to control debt before it accrues interest and that interest compounds.
To answer the question posed earlier, $100 would become $162.89 if it was in a savings account that paid five percent interest a year for 10 years. In 10 more years, that same $100 would grow to $265. In 50 years that $100 would turn into $1,146.