You've probably heard of the term 'interest' being mentioned before, but have you heard of interest on interest? It's like earning money on top of the money you've already earned. Keep reading to learn what it means.
What is interest on interest?
Interest on interest means earning extra money on the interest you've already earned. Let's say you save $100 and it earns you $5 in interest. Instead of taking that $5 out, you leave it in your savings. Now, that $5 also earns interest, adding to your original $100. Over time, this could increase significantly, helping your savings grow faster as you earn interest on top of the interest.
Interest on interest formula and example
The interest on interest formula helps you figure out how much your savings can grow over time. Here's how it works:
Formula: invested amount x (1 + interest)^time interval
Let's break it down:
"Invested amount" refers to the initial sum of money you put into savings or an investment.
"Interest" represents the rate at which your money grows over time. It's usually expressed as a decimal, like 0.05 for 5%.
"Time interval" is the duration for which your money stays invested, measured in years.
Now, let's illustrate this with an example:
Suppose you invest $100 at an annual interest rate of 5% for 3 years.
Using the formula:
$100 x (1 + 0.05)^3
= $100 x (1.05)^3
= $100 x 1.157625
= $115.76
So, after 3 years, your initial investment of $100 will grow to approximately $115.76 due to interest on interest. This demonstrates how even a small amount of money can grow significantly over time through the power of compounding interest.
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Interest on interest versus inflation
Interest on interest and inflation are two important concepts that impact the value of your money over time.
As we've seen, interest on interest, also known as compound interest refers to the process of earning interest not only on your initial investment but also on the interest that accumulates over time. This means that your money can grow faster because you're earning interest on top of interest. It's like a snowball effect that helps your savings grow exponentially.
Inflation, on the other hand, refers to the general increase in prices of goods and services over time. When inflation occurs, the purchasing power of your money decreases because the same amount of money buys fewer goods and services. In other words, inflation erodes the value of your money over time.
How do you create the interest on interest effect?
Creating the interest on interest effect is all about letting your money work for you over time. Here are two simple ways to do it:
- Long-term savings with interest: When you save money in an account that earns interest, like a savings account or a certificate of deposit (CD), you're laying the groundwork for the interest on interest effect. The interest you earn gets added to your original savings, and then you start earning interest on that total amount. Over time, this could significantly increase.
- Reinvestment of share dividends: If you invest in stocks that pay dividends, you have the option to reinvest those dividends back into more shares of the same stock. This means that you'll own more shares, and as a result, you'll receive more dividends in the future. By reinvesting dividends, you're essentially harnessing the power of compound interest. Over time, this could significantly boost the value of your investment portfolio leading to greater wealth accumulation.
Summary
As you've seen, interest on interest is like a magic trick where your savings grow faster over time because you earn interest not only on your initial investment but also on the interest you've already earned. Learn this concept to make your money work harder for you.
