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Understanding Compound Interest For Better Personal Finance Management

Updated on May 2, 2013

How Compound Interest Affects Your Personal Finance

Compound interest can work for you or against you, depending on your personal finances. It is surprising how many people are unaware of the effect compound interest can have on their finances and what simple steps can be taken to make it work in their favour.

Savings and investments.

The great thing about compound interest when saving is that not only does the money you are saving earn you interest, your interest earns interest. This is why your savings will grow faster than you would expect based on your money invested alone. For example if you were to invest £100 per month for ten years at 0% interest, at the end of the term you will have saved £12,000. This is simply £100 x 12 months x 10 years. But say you invested the same £100 over 10 years but this time with interest at 4%, you would have £14,694. That's £2,694 more! The interest has compounded on top of the previous month’s balance including the interest. If you were to simply take £12,000 and add 4% you would gain £480, so you can see that by saving monthly, even relatively small amounts can in time add up to even greater savings because of the compound interest.

Interest
Interest | Source
Money
Money | Source

Mortgages and loans.

Compound interest is great for saving but it works against you when it comes to borrowing money. This is why the full cost of a mortgage is so much greater than the original mortgage amount. Mortgage lenders are normal very quiet about compound interest as it obviously works in their favour. They want you to pay off your mortgage over a longer term so that they make more money from the compounded interest they charge. This is why they are reluctant to encourage you to pay off you mortgage earlier.

Paying off loans.

The truth is, if individuals were to pay even slightly more of their mortgage each month, above the minimal amount, not only would the mortgage be paid off quicker, they would potentially save thousands of pounds in the process. One argument I once heard was that if a person didn't have a mortgage they would have to rent anyway so why worry about paying it off quicker. Well, if someone said they would give me thousands of pounds and all I had to do was over-pay my mortgage each month, I would jump at the chance.

When it pays not to over-pay.

It doesn't pay to over-pay your mortgage if you can make more interest on the money by putting it into savings or if you have other debts with a higher interest rate, such as a credit card, which you should try and reduce first.

Having an awareness of compound interest and how it affects your personal finance can lead to better management of your money and make it work more effectively for you.

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