The mention of the magic of the compound interest may seem like a buzzword used by the financial advisors or investment experts. There is a thing, though, here is the truth: compound interest is not magic. It is elementary arithmetic with a strong influence, and it is the silent influence that may help any small savings grow into a large fortune with time.
This can be a game changer to the way people handle money, especially in the United States where most people are saving towards retirement, a home, college tuition of their children or at least financial security, so by understanding how compound interest works, this can totally change their thinking when it comes to money. In simple terms, let us have it.
The Poetic Definition: Make Interest on Your Interest
Fundamentally, compound interest implies that you earn interest, not only on your original amount (you have the principal) but on the pre-existing interest as well. That is, now your money begins to earn more money – and that the growth increases.
We can compare it to simple interest which only earns you on the initial amount one invested.
Here’s a quick example:
Assume that you invest 1000 dollars with an annual interest of 5%.
>Simple interest would see you earn $50 on an annual basis. >In 10 years, you would have $1,500 your initial investment of 1,000 and the interest of 500. >The interest with compound interest is however added back to the account annually, so the following year you are going to earn interest on 1,050 and not only 1,000.
In 10 years, you would be earning approximately 1629 without lifting a finger. That is another 129 dollars to make your money multiply itself.
And now consider what would happen in 20 years, or in 30 and 40 years – that difference becomes very large.
The Formula (and Why It Matters)
Just in case you want to know how your money is growing using the basic form of compound interest, the following is the formula:
[ A = P (1 + \frac{r}{n})^{nt} ]
Where: A = the value of the amount after time t. P = the initial principal (your principle amount) r = the interest rate per annum (expressed in decimals) n = the number of annual interest compounds. t = years of investment in the money.
There is no need to be a math genius to use this. There is the work that can be done by online calculators. However the realization obtained by comprehending it are that the most significant growth aspects are frequency of compounding and the duration time spent in it.
The Real Secret Ingredient Is Time
Compound interest is the best when you provide it with one thing time.
Consider it to be as planting a tree. During the initial years, it develops at a slow pace – however, at some point, it begins to increase at a higher rate and its branches extend further. This is the reason why the success of each year builds on the previous year.
An example of how time can be a formidable thing can be seen in the following:
Age at which You begin investing monthly investment Annual return Value at 65 Years old
25 $200 7% $524,000 35 $200 7% $245,000 45 $200 7% $108,000
Beginning only 10 years ago effectively doubles your final value – though the monthly deposit is the same. That is the power of compounding time, not money.
The Real Life Process of Compounding
In nearly every aspect of your financial life in the U.S.: Compound interest has a role:
a. Savings Accounts
The majority of the U.S. banks provide interest-bearing savings account but the rates are generally low (0.5%-4%). The best thing is that these accounts earn interest either on a daily or monthly basis, that is, even your temporary savings will be accumulated with time.
b. Certificates of Deposit (CDs)
CDs have predictable interest rates over a given period (1 or 5 years). The interest accumulates during that period usually on a quarterly or annual basis. They are safer than stocks and typically provide higher returns as compared to a basic savings account.
c. Retirement Accounts (401 (k) IRA, Roth IRA)
Compounding is where it is the most effective. It is not that your retirement savings increase by what you put in them but rather by the earnings of investment reinvested back. Dividends, interest and capital gains compound over decades and bring your nest egg to the moon, particularly when you begin when you are young.
d. The Dark Side of Compounding: Credit Cards
Regrettably, compounding may (also) play against you. The interest will grow on a day-to-day basis when you carry a balance in your credit card. It is how credit card debt can get out of control so fast. In the case of 5000 at 20 per cent interest and you make minimum payments, you may end up paying up thousands of dollars as interest.
Compounding is therefore a two sided sword: it eventually can increase your savings – or debt.
The Frequency of Compounding: What Is the Frequency?
It is not always once a year that the compounding takes place. The more often it is your interest doubling, the more your money doubles.
Here’s what that means: Annually = once a year Quarterly = four times a year Monthly = twelve times a year Daily = 365 times a year
Suppose you had 10,000 dollars, and the interest rate is 5 percent a year and you hold the money 10 years:
Annual compounding = $16,288 Quarterly compounding = $16,386 Monthly compounding = $16,470 Daily compounding = $16,486
The difference may not be much after a decade but after 30 or 40 years, the extra time of compounding will contribute a lot particularly in an investment or retirement account.
Inflation and Real Returns
One point to keep in mind: not every growth of interest is a real growth.
In case your savings account has an interest rate of 3 percent, and inflation is at 4 percent, you will find that the purchasing power of your money diminishes. This is the reason why most Americans invest in the stock market or index funds and bonds, they are likely to provide better returns over the long run that will beat the inflation.
The S&P 500 has had a historical average annual after-inflation returns of approximately 7% over the last 100 years – that is, you can easily increase your money 2 to 1 in about 10 years.
The Rule of 72
To get a fast, back-of-the-napkin, estimation of the time your money will be doubled, use the Rule of 72.
All you have to do is to divide 72 by your annual interest rate:
With a 6 percent rate, you can get the return after 12 years doubling your money. It takes approximately 9 years at a 8% return. It takes approximately 7 years at a 10 percent return.
This is a simple trick, yet it will help you think about how quickly compounding growth.
How to make Compounded interest Work in your favor
In case you are serious about growing rich, then here are the practical uses of compound interest:
- Early Start – Every little counts. With time, a 22-year old, spending $100 a month, wins over a 35-year old, spending $200 a month.
- Be Consistent – Start an automatic deposit to your savings or investment funds.
- Reinvest Earnings – Do not collect dividends or interests; reinvest the earnings so that they can continue to compound.
- Do not use a High-Interest Debt – It is like making a 20 percent guarantee on your money.
- Think Long-Term – It rewards patience. It is tempting to withdraw your money because of fluctuating markets.
The Bottom Line: Compounding Is Your Financial Superpower
The compound interest is not merely a financial concept but an attitude. It is a reward of obedience, patience and time.
Saving a couple of dollars a week or something bigger than that, the sooner you get started, the more effective compounding is. It is silently accumulating wealth and you are asleep and day after day and year after year.
Albert Einstein supposedly referred to the compound interest as the eighth wonder of the world. As he said or said not, the fact is that the phrase is true; those who know it have it; those who know not, have it.
So start now. It will pay your future self, make your future self a lot richer.
In short: The driver of every growing dollar is compound interest. It is not by chance, it is not magic, it is math. And when most profitably to have it?
Also Read : Personal Loan vs Credit Card Loan: Which is Better
Follow Us: Youtube
