How can my money make money for me? Compound interest.
Two of the main ways interest affects people are savings accounts and debt payments.
You pay interest on overdue bills, like credit cards, and earn interest on savings accounts.
When you put your money into a savings account, the bank gets to use your money for other things. Most commonly, they lend it to other people.
That’s where they get money to lend people money for mortgages to buy houses or other loans. They take it from deposits other people make. (Yes, really.)
That’s why they have money to pay you interest on your savings account.
Interest rates on savings accounts vary by year and bank. But let’s say I open a savings account that pays 1% interest annually and deposit $1,000 today. The original amount is called the principal balance, $1000. The interest rate is also called the rate of return.
If they paid interest once a year, I’d make 1% of $1000 or $10 a year.
But they actually pay interest every month, so it compounds. In other words, if you leave the interest in the account, you are getting paid interest on the interest you made last month.
Account makes 1% on $1000 = $1000*(1%/12) monthly for a year = $10.05
You’d have $1010.05.
It doesn’t sound like much but at the end of five years, you’d have $51.25 on the original $1000.
To calculate how much interest you would earn with your savings and different interest rates, check out this Compound Interest Calculator.