Let’s start with the basics.
This graph here represents the money you have.
The y-axis is the money you have, and the x-axis is your Time Horizon.
Your time horizon is how long you plan on doing something with your money.
So, if you plan on saving for a vacation in one year, then your time horizon
would be one year.
Now lets say you’re making some recurring deposits,
or putting a set amount of money into a chequing account at regular intervals.
The graph shown here is showing
$200 a month.
After 12 months, you end up with $2 400.
But... notice your growth is pretty linear?
Lets change that.
With something like a savings account, the money you put in — called your
Principal — earns a little extra money,
usually a small percentage, like 2% per year.
(For sake of display, the graph is exaggerated).
This happens because whatever bank you have the account with uses that money
— usually by lending it out — and pays you that extra
called interest for the privilege.
Interest is usually expressed per year, but it isn’t always calculated and paid once per year,
it just means that at the end of the year it totals the per-year rate.
Compounding periods is how frequently interest
is calculated and actually paid.
So if you have a rate of 2% per year, but it “compounds” every month,
that means every month whatever you have has 0.167% (2% divide by 12 months)
added to it.
But... can the interest you earned previously also gain interest?
For most cases, yes! This is called compounding interest.
With compounding interest, the added interest you earned last compound period is
treated like an add-on to the principal, meaning next time you get more in an interest
payment even if the rate doesn’t change.
Thats all the basics, but what if you wanna understand it some more?
Or maybe you already got a savings account and you just wanna make a plan?
We have a charting tool, just for you!