What is Compound Interest?
Compound interest is interest earned on interest. Sound like a tongue twister? Compound interest is actually pretty simple, but it could have a powerful impact on your finances. Let's see why you should care about compounding interest as a college student!
First, you need to know what simple interest is. This is when your principal (the amount of money you start with) increases by a certain percentage each year. Your principal will grow slowly but steadily over time. For example, $10,000 growing at 5% will be $22,500 after 25 years.
Compound interest is when interest also grows on earned interest, not just on the principal. So, that same $10,000 growing at a 5% compounded interest rate becomes $33,863.55 after 25 years. That’s quite a big difference. Whether you’re paying back a student loan or saving for retirement, compound interest means you’ll be looking at a much larger total than you started out with. Especially if interest is allowed to grow over a long period.
You can use an online calculator to figure out how compound interest grows over time. You may also use the following equation: FV = PV x [1 + (i/n)](nxt)
- FV = future value
- PV = present value
- i = interest rate
- n = compounding periods per year
- t = time in years
Why You Should Care About Compounding Interest as a College Student?
Thanks to the power of compound interest, saving even a little bit at a young age could really add up by the time you’re older. In fact, when you start saving matters more than how much you save each month.
Say you start saving $500 per month when you’re 20 years old, with a compound interest rate of 5%. You save every month until you turn 30. After those 10 years, you stop saving, because other goals get in the way. You’ve put aside a total of $60,000.
That’s $16.66 per day. Not much more than the cost of lunch at a restaurant. And by the time you’re ready to retire at age 65, you could have saved $541,921.84. All thanks to compound interest. But what happens if you start saving later. You begin saving for retirement when you turn 45. To catch up, you save $500 per month for 20 years instead of 10. Compared to the last scenario, you’ve banked twice as much: $120,000. So, you should be on track, right? By the time you reach retirement age, you’ll have just $286,362.59. The gains aren’t nearly as great compared to starting early.
What Every College Student Should Know About Saving Money
If you’re like many college students, you may not have a lot of cash to spare. But it’s still important to start thinking about saving. Here are five things you should learn about saving money by the time you graduate:
- It's ok to start small. Remember, compound interest is your best friend. It could help modest savings turn into enough to help you reach your goals. Even if you could only save $25 or $50 per month, that’s a good start.
- You have more money than you think. If you haven't developed a saving mindset, you might believe you're always broke. But take a hard look at your spending habits. Fast food meals and fancy coffee drinks add up. Cutting out just a few splurges per month could help you jumpstart your savings.
- Time is on your side. For college students, retirement may seem ages away and that's a good thing if you start saving now, it’s time and compound interest that could help your money grow. So, don’t make the mistake of thinking you have all the time in the world to start saving.
- Saving is easier when you’re younger. Sure, you may not earn as much out of college as you hopefully will in middle age. But older adulthood may bring increased financial responsibilities such as a house, kids, and your kids’ college educations. So, start saving as much as you can while you are still young, and let compound interest work its magic.
- Debt doesn't cancel out saving. It may be tempting to put off saving until you’ve paid off your student loan debt. But, you should save for retirement and pay off your loans as quickly as possible at the same time. If your job offers employer matching contributions to your 401k, take advantage of that option.
Compound Interest and Student Loans
If you borrowed student loans, compound interest could impact how much you pay over the life of your loans. As you know, you not only have to pay back your loan’s principal, or the amount you borrowed. You need to pay interest on your student loans, too. The longer you take to pay off your loans, the more interest will accrue over time.
In many cases, student loans are deferred until graduation. That means you don’t have to start paying back what you borrowed until you’re done with school. So, interest has time to grow. Once you begin repaying your loan, any unpaid interest on your loan will start accruing interest, too. That’s compound interest at work!
Some borrowers need to forbear a loan. Forbearance means you stop paying for a while, due to financial hardship. But interest will continue to compound during forbearance. So, you end up paying a lot more in the long run.
Tips to manage compounding interest on your student loans:
- Pay the interest while in school. Look for a lender that lets you make interest payments while you’re still in college. If you have a part-time job or help from a parent, these payments may be manageable. And, you could save money over the life of your loan.
- Be wary of graduated repayment plans. These are when your loan payments increase over time. Sure, that could make it easier to afford payments when you first start working. But sometimes these plans can end up increasing your debt. Why? Because to start, your minimum monthly payment may not be enough to cover interest and compounding interest. Do your research before choosing one of these plans.
- Pay more than the minimum, if you can. Paying off your debt as quickly as possible means you’ll pay less in total, over the life of your loan. So, plan to make the biggest monthly payment you can afford.
How to Use this Knowledge to Help Get Out of Debt and Save
Hopefully, you now have a better understanding of how compound interest works. You should have a clearer picture of how savings and debt increase over time. Money you invest now will have a chance to grow more than you may have thought possible. With that same logic, the money you borrow now could grow out of proportion, leaving you with a lot of debt. So, it’s important to get in control of your finances and use time to your benefit. That means letting your savings grow for a long time. It also means paying off your debt in a short period of time.
5 Ways to Get Started Now
Here are some ways to harness the power of compound interest by saving and investing. But remember, investing is never a sure thing. Know the risks before you get started. You may want to seek advice from a pro and don’t take shortcuts. Many people don’t “get rich quick.” They make thoughtful investments, with small gains that add up over time.
- Open a high yield savings account. Many banks don’t pay much interest on savings. But some banks offer high-yield savings accounts that pay much higher interest. You may need a certain amount of money to open one. Compare banks to learn your options.
- Try a savings app. A good app could help make saving easy and automatic.
- Invest in a certificate of deposit. A certificate of deposit (CD) may be a lower risk way to invest, because it’s insured by the federal government. It might pay better interest than a typical bank account. The longer the CD takes to mature, the more interest you could earn on the investment.
- Get help from a robo advisor. New to investing? It’s wise to seek some financial advice. Robo advisors are a type of financial advisor that helps manage your investments. This may be more affordable than paying for advice from a human. Robo advisors could help you reach your goals while reducing some of the risks of investing on your own.
- Buy S&P 500 index funds. An index fund includes shares of hundreds of companies. So, it’s highly diversified and spreads out the risk. Buying an index fund may be a great way to start investing if you don’t have much knowledge yet.
Facts about Compounding Interest
Want to share the full infographic image on your site? Just copy and paste the embed code below: