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What is Compound Interest? | General Questions

Compound interest is a financial concept that plays a pivotal role in the growth of investments and the accumulation of debt. Unlike simple interest, which is calculated solely on the initial principal, compound interest takes into account the accumulated interest from previous periods. This compounding effect allows interest to be earned or charged not only on the initial amount but also on the interest already accrued.

Why is this important?

Simply put, compound interest is like a snowball that grows bigger and faster over time. When you save or invest money, compound interest helps your savings grow not just based on the original amount but also on the interest you've earned. As time goes on, you earn interest on both the money you put in and the interest it has already accrued. This snowball effect means that the longer you leave your money invested, the more it can grow over time. On the flip side, if you have debt, compound interest works against you. The interest you owe keeps adding up, not only on the initial amount but also on the interest that has accumulated. That's why it's important to be aware of compound interest and take advantage of it when saving or investing while also being mindful of its impact when borrowing money.

How does it work?

Here is an example: Suppose you have a loan with an initial principal of $30,000 and an annual interest rate of 6%. If the interest compounds monthly, the interest accrued each month would be added to the outstanding balance, increasing the total amount on which future interest calculations are based (i.e., $30,000 (1 + 0.06/12)^(12 * (1/12) = $30,150). Over the repayment term, the compounding interest can significantly increase the total amount repaid. To minimize the impact of compound interest on loans, borrowers can explore options such as making extra payments towards the principal or refinancing the loan to a lower interest rate. 

How does Earnest calculate interest?

Here at Earnest, we use the "simple daily interest" method. Unlike compound interest, which takes into account the accumulated interest, simple daily interest is calculated on the outstanding or unpaid principal balance. The interest is determined by multiplying the principal by the interest rate and then dividing it by the number of days in a year. This means that interest accrues each day in an amount equal to 1/365 times your interest rate multiplied by your remaining principal owed.

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