Whether you’re an investor or a saver, growing your wealth over time is important. One of the best ways to do that is by understanding the power of compound interest.
What is compound interest?
Compound interest is the interest earned on an investment or savings account that builds upon itself over time. Instead of just receiving the original interest earned, the interest earned is reinvested and earns additional interest.
This creates a snowball effect that can significantly increase the growth of your savings or investment over time. Using a powerful tactic like compound interest can supercharge your wealth building. You can apply this to all types of financial investments such as retirement accounts, stocks, and real estate.
The power of compound interest
Let’s say you invest $1,000 into a savings account that pays a 5% interest rate. After one year, you would have earned $50 in interest, bringing your total balance to $1,050. However, with compound interest, the interest earned in the first year is reinvested and earns additional interest in the second year. If you continue to reinvest the interest, your balance can grow exponentially over time.
Looking at year two, the $50 in interest earned in the first year would earn an additional $2.50 (5% of $50). Your total balance would now be $1,102.50, which is $52.50 more than if you had just received the original interest and didn’t reinvest it. And the growth continues year after year, with the interest earning additional interest.
This is why compound interest is often referred to as “the magic of compounding.” It has the potential to turn small investments into significant sums over time. You just have to find the right place to put your money and be patient!
The earlier the better
One of the keys to maximizing the power of compound interest is to start early and invest for the long term. The earlier you start, the more time your money has to compound, and the larger your balance can grow.
Example #1: Initial Investment
You invest $10,000 at the age of 20. We’ll use 7% for the interest rate (average return for investments) and reinvest the initial amount and interest accrued for 40 years. By age 60, your balance could grow to about $150,000 from just letting the money do the work for you!
Compare that to if you waited until you were 30 to start investing that same $10,000. Your balance would only grow to about $76,000 by age 60. This is simply because you have ten less years of utilizing the power of compound interest.
Now let’s look at a more complicated example.
Example #2: Recurring Investment
You invest $1000/year every year from age 20 to age 60. Again, 7% will be the interest rate and the interest plus principal will be reinvested for 40 years. By age 60, you will have accumulated just about $200,000!
If you had just saved $1000 each year without investing any of it, you would only have $40,000. That means you made $160,000 through compound interest alone.
The effect of interest rates
Another important factor to consider when maximizing the power of compound interest is the interest rate. The higher the interest rate, the faster your balance can grow over time.
This is why it’s essential to look for investment and savings options that offer the highest possible interest rate, and to regularly compare your options to make sure you’re getting the best deal.
Compound Interest is for everyone!
Compound interest is also important for anyone who wants to build wealth over time, regardless of their income level. Unlike some investments that may require large sums of money to start, you can start investing with as little as $50 or $100.
By starting early and reinvesting the interest, you can watch your balance grow over time. This will help build a strong foundation for your financial future.
Compound Interest for Debt
It’s also important to note that compound interest can work against you if you have debt This includes credit card balances or student loans. The interest charged on these debts can compound, making it more difficult to pay them off over time.
Related: Tips when using a credit card
This is why it’s essential that you focus on paying off high-interest debt as soon as possible, and to only invest in savings or investment options once your debt is under control. It is a key part of learning how to budget early on in life.
Final Thoughts
Compound interest is a powerful tool for growing your wealth over time. By starting early, investing for the long term, and continuously reinvesting, you can take advantage of the magic of compounding. You will be able to build a strong financial foundation for your future if you focus on this strategy.
Whether you’re just starting out on your financial journey or looking for ways to grow your existing savings, appreciating the power of compound interest is essential for achieving your financial goals.
