Because it’s no secret that wise financial planning and investments have helped the wealthy accumulate their fortune, compound interest is one of the most crucial tactics they employ.
And that’s exactly what we will explain this week: compound interest, how it operates, and how banks have been exploiting it against us for years in this blog article.
Let’s first define what compound interest is:
“Compound, to savers and investors, means the ability of a sum of money to grow exponentially over time by the repeated addition of earnings to the principal invested. Each round of earnings adds to the principal that yields the next round of earnings. In savings accounts, this is called compound interest.”
James Chen – investopedia.com
To further comprehend compound interest, let’s look at an example. Imagine you put $1000 into an investment with a 5% yearly interest rate. The amount you would have made at the end of the year is $1050.
At the conclusion of the second year, interest would be computed on both the $1,000 principal amount and the $50 in interest that was earned in the first year, in addition to the $1,000 principal amount. As a result, you will get interest on $1050 rather than simply $1000, increasing your total to $1102.5.
As the process is iterative, your earnings will continue to increase rapidly.
We’ll now examine the ways banks have used compound interest against us. On money we borrow from banks, they often pay compound interest, but not on money we save. Thus when we borrow money, we really wind up paying more in interest than what we actually borrowed. For instance, if you borrow $10,000 at a 10% compound interest rate, you will pay $11,000 in total at the end of the year (principal + interest).
One of the most potent financial ideas ever devised is compound interest. It may help you increase your money dramatically over time if applied properly. Compound interest, however, frequently works against you and has a detrimental effect on your financial situation when it comes to banks.
What banks do to us by using compound interest:
First, credit cards
One of the most popular ways that banks take use of compound interest against consumers is through credit cards. Every month interest is applied to your outstanding debt while you have a balance on your credit card. You then pay interest on top of interest since this interest is added to the main sum. This might result in a sizable amount of debt over time.
Let’s imagine, for illustration purposes, that you have a $1,000 credit card balance with an interest rate of 18%. If you only pay the minimum required each month, which is $25, it will take you over 6 years to pay off your debt, costing you almost $1,500 in interest payments alone.
Another method that banks exploit compound interest against consumers is through mortgages. In essence, when you take out a mortgage you are borrowing money and throughout the course of the loan are paying interest on that borrowed amount. You are paying interest on top of interest since this interest is compounded each month.
Let’s imagine, for illustration purposes, that you obtain a $250,000, 30-year mortgage with a 4% interest rate. You’ll wind up paying interest alone of almost $143,000 over the course of the loan. This is due to the fact that your loan’s interest is compounded each month, meaning you are paying interest on top of interest.
In conclusion, when utilized properly, compound interest may be a potent financial instrument. It’s crucial to understand how banks use compound interest against us when it comes to banking, though. Understanding how interest rates and compounding operate will enable you to make wiser financial decisions that will support the achievement of your objectives and the long-term accumulation of wealth.
And if you have been paying attention to the majority of our blog posts and Newsletters, our model allows you to invest like a bank, turning the gears in your favor while you also help families.
How? We’ll tell you how in our next newsletter. See you next week!