Wednesday, February 24, 2021

When Compound Interest Works Against You

Seasoned investors who harness the power of compound interest make it a habit to thoroughly read the prospectus of the financial instruments they choose. In the case of a high-yield savings account, for example, they want to learn not only the guaranteed annual percentage yield (APY) but also the frequency at which the interest will be paid. Quite a few banks offer daily compounding, which means that they will pay the interest at the end of the day.

Understanding Compounding Interest Debt

Knowing the APY and the compounding frequency are useful when you sit down to calculate your investment horizon and see how your financial goals stack up. Reading the fine print and paying attention to every detail is something you should also be doing with regard to the disclosures that come with credit cards and loan paperwork; doing this will reveal many aspects of personal lending that may surprise you, and one such aspect is the fact that most credit card issuers charge compound interest on a daily basis.

take a good look at their loans and credit cards

When you are the one paying compound interest to others, the financial disadvantage can be significant. In order to balance things out, the compounding you earn should be higher than the one being charged against you. Under the current interest rate climate, credit card issuers will always have the upper hand because they can compound much higher rates on a daily basis compared to bonds, certificates of deposit, high-yield accounts, and even stocks. Only cryptocurrencies such as Bitcoin could give you an advantage in this regard, and we all know that this is a very risky and volatile investment.

The lesson here is that compound interest investors should take a good look at their loans and credit cards; whenever you are able to reduce pay off debt that carries a high rate of interest, you should prioritize accordingly. Carrying high-interest debt that is compounding against you will keep you in a financial hole that can only get deeper.

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