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compound interest1. How is compound interest used?

Compound interest is most often used to calculate the value of an investment in which the interest that is accumulated is added back into the account.  For example, let’s say I invest $10,000 at 5% interest per year.  After 1 year, I have $10,500 because I made $500 in interest.  But the next year, I earn 5% interest on the now $10,500, which is another $525.  Now I have $11,025 and so on.

2. What do volatility and rate of return have to do with compound interest?

Volatility can only affect an investment that does not have a set return rate.  For instance, if you invest in a bond that pays 3% interest, volatility makes no difference; you get 3% interest every year not matter what happens.  On the other hand, imagine you invest in a stock (that pays a dividend).  The amount you recieve as a dividend will be higher if the stock goes up but will be lower if the stock goes down.  Obviously the more money you make (rate of return), the faster your investment will compound, or increase in value.

3. How can compound interest affect you in a negative way (i.e. credit
cards)?

Compound interest can affect you negatively if you are paying it.  For instance, let’s say you buy a new T.V. on your credit card for $1000 at 22% interest.  That’s $220 a year (it’s actually more but I’m keeping the math simple) but you credit card company will only make you pay about $35 a month, or $420.  Thus, if you are only paying minimum payments, you’ve only lowered your balance by $200.  This is because each day, you accumulate a tiny bit of interest.  The next day, you accumulate a tiny bit of interest on the NEW amount, which is slightly higher than yesterday.  This continues forever, until you pay your credit card off completely.  But with compound interest at play, this could literally take decades if you only pay your minimum payment.

4. How can it affect you in a positive way (i.e. savings and investments)?

Anytime you are receiving compound interest, you benefit.  For instance, most of us have a 401k.  You invest money and it increases in value.  Then, it grows further but it grows on the previous growth as well.  You literally have growth on growth.

5. If planning your savings using CI, how should a consumer think about the rate of return/assumption to include in their plans?

You are not just earning interest with compound interest.  You are earning interest on interest.  In fact, given enough time, the amount of interest that is accumulated will surpass the amount that is even invested.  For instance, if you work your whole life and accumulate $3,000,000 (evenly) in your 401K over 40 years, only around 10% will be money you actually invested.  The rest is interest, i.e. FREE MONEY!
Paul Claybrook, MS, MBA
TheMarketMadeEasy.com