Compound Interest: Best Friend or Worst Enemy?

The key to making compound interest work for you lies in understanding it.

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Albert Einstein once proclaimed that compound interest is the greatest force in the universe. This is a powerful statement coming from the man who developed the Special Theory of Relativity (E=mc2) and whose research was fundamental in unlocking the secrets of atomic power.

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This seems like an overstatement when taken at face value. But when examined closely, you realize the true brilliance of the statement. Compound interest truly is one of the most powerful forces in the universe. Check out this compound interest graphic to see a visualization of compound interest at work.

When compound interest is your best friend. Compound interest is an investor's greatest tool and can work wonders for your investment portfolio. Compound interest works best when you have a large starting balance and a lot of time, as the gains become almost exponential as time goes by. Earning more money from your money is every investor's dream! But you don't need a large balance to start gaining the benefits of compound interest. You just need to get started; compound interest can work on any amount.

How to harness the power of compound interest. The best way to harness the power of compound interest is to start saving and investing now. If your saving goals are short term, then go for standard savings account or CD. If you are looking for a long term investment, then consider opening a Roth IRA or other retirement account where you can gain long term tax advantages.

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When compound interest is your greatest enemy. You wouldn't want an atomic bomb in the hands of you worst enemy, but that is exactly what compound interest is when it is working against you. When you incur debt, you pay interest to the lender until you repay the loan. If you don't pay more than the monthly interest charge, your bill will continue to increase each month until the debt becomes almost insurmountable. This is rare for standard loans such as a car loan or a mortgage, but it is a real possibility if you only make the minimum payments on credit cards, which often don't cover more than the interest and finance charges. Making minimum payments makes it easy to stretch out your loan almost indefinitely, resulting in total payments that can be hundreds or even thousands of dollars more than the original purchase.

How to defeat compound interest when it is working against you. Pay off any debt as quickly as possible. Making extra payments will reduce the principle amount on your loan, reducing the time it takes to repay your loan and the amount of interest you pay over the course of your loan. You can also refinance a loan to take advantage of lower interest rates, further reducing the amount of time it takes to pay off your loan and the amount of interest you pay. Now is a great time to refinance a mortgage or transfer your credit card balance to a 0 percent credit card.

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Compound interest can be your best friend, or your worst enemy. But you don't have to take my word for it:

"Compound interest is the eighth wonder of the world. He who understands it, earns it... he who doesn't... pays it." —Albert Einstein

Ryan Guina is a U.S. military veteran, writer, and professional in the corporate world. He blogs at Cash Money Life and The Military Wallet.