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How to use compound interest to your financial advantage

February 4, 2013

Times are hard for ordinary, hard-working people in the UK at the moment. High unemployment, stagnant wages and rising inflation are having profound effects on families all over the country. While low interest rates are good for borrowers, your savings could be diminishing if the interest rate you are receiving is lower than inflation. However, getting your head around the issue of compound interest could allow you to better arrange your financial affairs, and that can put more money in your pocket every month.

What is Compound Interest?

The mere mention of compound interest has many people running to the nearest accountant for advice, but the basic principles are very simple. A capital investment – in most cases your savings – attracts interest. A bank or financial institution uses your money to invest, and the interest is your cut of the profit it makes. The following year, interest is paid on the initial capital investment – as well as the first year’s interest. Plainly speaking, compound interest involves earning interest on your interest. A snowball effect quickly becomes apparent, as each year brings a new interest payment.

How Can I Make Compound Interest Work for Me?

Protect Yourself from the Banks! Compound interest can be used against you. Wherever possible, credit cards should bills should be paid in full every month – otherwise you could be at the other end of the compound interest miracle. It is not unusual for people to become embroiled in a spiral of debt by failing to clear debts as quickly as possible.

Start Investing at a Young Age

The more years you save or invest, the more times compound interest will take effect. Unfortunately, far too many people wait until they are in their forties before beginning to save or invest for their future. You must keep your long-term goals in mind; paying into an investment fund may be painful when the results are four decades away, but the rewards make the sacrifice worth it. Compound interest works for you; by making an initial capital investment, you are guaranteed progressively higher rewards for as long as your investment exists. What’s more, you can add to your capital outlay over time, and that can really accelerate your financial well-being.

Fight for Every Percentage Point

A great example of the power of compound interest can be found by examining the purchase of Manhattan Island for goods to the value of around $16 in 1626. Had those native Americans invested that money into a Dutch savings bank with an annual interest rate of 6.5%, they would have been sitting on an eye-watering $1 trillion in 2005 – enough money to buy all the real estate in the five boroughs of New York City. However, had the native Americans settled for an interest rate of 6%, their nest-egg would be a mere $150 billion – hardly enough money to buy the borough of Queens!

Don’t be a Frog!

Albert Einstein once said: “Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t, pays it.” Einstein couldn’t have stated the case more eloquently. An ancient proverb tells the tale of a frog that is relaxing in warm water. Although the temperature of the water is gradually increasing, the increases are small, and the frog adjusts. However, once a certain temperature has been reached, the frog is boiled to death. Millions of people in the UK are guilty of acting like the proverbial frog. They are sitting on investments or debt that are gradually causing harm to their finances; and like the frog, they won’t realise the significance of these subtle changes until it is too late to do anything about them. You must take control of your finances to make sure that compound interest puts money in your pocket – instead of bleeding you dry!

References

http://www.goodreads.com/quotes/76863-compound-interest-is-the-eighth-wonder-of-the-world-he
http://www.worldfinancialblog.com/investing/the-magic-of-compound-interest/
https://www.khanacademy.org/science/core-finance/interest-tutorial/compound-interest-tutorial/v/introduction-to-compound-interest
http://www.savingadvice.com/articles/2006/01/15/10341_compound-interest-manhattan-the-indians.html
http://en.wikipedia.org/wiki/Boiling_frog

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