Scott Tominaga: How Does Compound Interest Work?

 

Scott Tominaga: The Power of Compound Interest

When it comes to earning interest, there are two basic choices: simple and compound. Simple interest means you get a set percentage of the principal amount every year, says Scott Tominaga.

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For example, if you invest $500 at 5% simple interest for 10 years, you expect to receive $25 in interest every year for the next decade. In the investment world, bonds are a good example of an investment that usually pays simple interest.

What is compound interest?

On the other hand, Scott Tominaga explains that compound interest is what you earn when you reinvest your earnings, which then also earns more interest. Compound interest essentially means "interest on the interest."

For instance, let's say you invest $500 at 5% interest. After the first year, you receive a $25 interest payment, but instead of spending it, you decide to reinvest the interest earned at the same 5% rate. For the second year, your interest would be calculated on a $525 investment, which comes to $26.25.

You get the idea. Compound interest means your principal gets larger over time and will generate larger interest payments. Scott Tominaga notes that the difference between simple and compound interest can be huge.

Note that the S&P 500 has returned a long-term annualized average of around 10% since 1957. Returns like this, compounded over the years, can result in some really impressive performances.

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There's also a similar concept known as cumulative interest, adds Scott Tominaga. Cumulative interest is the sum of the interest payments made, but it generally refers to payments made on a loan. For instance, the cumulative interest on a 20-year mortgage would be how much you paid toward interest over the 20-year loan term.

Scott Tominaga, the Chief Operating Officer of PartnersAdmin LLC, is an experienced professional in the areas of middle and back office, accounting, compliance, and administrative functions within financial services firms. He has previously filled primary roles in forming several operational infrastructures. He also interfaced with fund managers and professional service providers to establish efficient, transparent operations and reporting structures. For more about his work, visit this page.