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What is compound interest and how does it work?

womanwithheadset30343063.jpgWhen dealing with investments on decision that you have to make is whether to make investments that accrue interest or compound interest. Most everybody understands the concept behind interest because it is money that you earn on the money that you invested; it is usually a set rate so you earn the same amount of interest each month. Simple interest is only earned on the initial amount of money that you have invested, even if you choose to reinvest the interest that was earned. Compound interest is bit different, but it is still money that you earn on the amount of money that you invested.

Compound interest is money that is earned on the principal amount that you have invested. What makes compound interest different from regular interest is that the interest that is earned is compounded each month because the money you earned in interest is added to the principal hat you have invested each month. How your compound interest works depends on what the terms of your investment are, it can be compounded daily, weekly, monthly, or even annually. The important thing to remember is that the more times the principal balance is compounded the more money you are going to earn, so it is best to compound the money each month rather than take it out and spend it on other investments.

If you have an investment that offers compound interest, your best choice is to leave the account alone, meaning you do not remove any money from it. With compound interest accounts, the only thing that you want to do is add money to the principal amount so that you earn more interest. The money that is being added to the account can be more money that you want to invest or it can be in the form of the interest that you are accruing each period. The more money that you have in the account the more money that you will make in interest each period, it follows the logic of the more money you have the more money you will make from it.

One of the best features of compound interest is that you can figure out exactly what your investment will be worth in a few years, all you need to have is the relevant information and a scientific calculator. The information that you need to have handy is the initial investment amount, the interest rate, the number of times per year that your investment will compound, and the number of years you plan to leave the money compounding in the investment. You will then use the following formula: Total Value = p(1 + r/t) ^ty.

Here is an example of how compound interest would work using actual figures. The amount of the investment is going to be $10,000 and you will be earning 5% interest on the account per year. The interest that you earn will be compounded monthly. In this example, let's say that you are going to leave the money in the account for a minimum of five years. With this information, using the above formula you can determine how much money you will make in the time period, which is going to be the value of your account after four years. To determine the amount you will need to plug the numbers into your scientific calculator, but this is what you would have. Total Value = 10,000(1 + .05/12) ^12X5. Solving this problem will give you the total value of $12,833.59.

One thing that you want to remember about compound interest is that even if a simple interest account is offering a higher yearly interest rate you will most likely still make more money with the compound interest account.

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