The Magic of Compound Interest
There is a very good chance that you have heard about the magic of compound interest. But do you know how it really works and how it can help you grow your money immensely? If you don’t know, you are in the majority.
According to ValuePenguin, 96% of Americans have no idea what compound interest means. I think everyone, especially young people, should know and make the most out of compound interest. After all, it can grow your wealth in a snowball effect. It can increase your savings, making them go from thousands to millions of dollars.
To make the most of it, you need to understand it first. In this article, I’m not only going to explain the concept of compound interest, but also help you use it. So, let’s begin.
Table of Contents
What is Compound Interest?
Compound interest makes your money grow faster than simple interest. This is because, in addition to earning returns on the money you invest, you also earn returns on those returns. This happens at the end of every compounding period. A compounding period could be daily, monthly, quarterly, or annually.
This is how compound interest makes your wealth grow faster. This is also the reason why you don’t have to put away a ton of money to reach financial independence.
When it comes to compound interest, the earlier you start, the better. If you start saving at age 25, your savings will be significantly more than if you start saving at, say, 30.
Compound interest can also work against you.
When it comes to loans, the amount you have to repay gets bigger. This means that the longer it takes you to pay off a loan, the more you will owe in interest. This means that if you pay this loan over 3 years, you will have to pay less in interest. But if you pay it off in over five years, you will owe much more.
Compound Interest Vs. Simple Interest
Regular interest works differently than compound interest. You calculate the usual interest based only on the principal amount. The interest that you earn does not compound in the case of simple interest.
Let’s say you have an account balance of $1,000. This balance earns an interest of 5% annually and so, it pays you $50 a year. The earned interest would not be added back into the initial amount. In year two, you would earn another $50.
In the case of compound interest, this initial amount would increase in year two.
Simple interest is usually used to calculate the interest charged on short-term loans, such as car loans. On the other hand, the interest charged on credit card debt compounds. This is exactly why credit card debts can get so huge for so many people.
In an ideal world, we would all want our savings and investments to be calculated with compound interest. And our debts to be calculated with simple interest. But that is just not the case.
How to Take Advantage of Compound Interest
Start Saving Early
When it comes to taking advantage of compound interest, the sooner you invest your money, the better. However, many people don’t know where to invest.
The simplest starting point for most people is to contribute to their employer’s retirement plan. This means your 401(k) plan. Many companies also offer retirement savings accounts. There are many other options for savings accounts, including IRA and Roth IRA.
Financial wizard Warrant Buffet is a big fan of compound interest himself. He recommends investing in low-cost index funds. These allow you to own a small share of many different companies.
For example, the S&P 500 is a fund that contains stocks of the 500 largest companies in the U.S. This includes Apple, Google, Johnson & Johnson, and many more.
No matter how you choose to invest, though, the most important thing is to open at least one account. You should start contributing to it consistently to take full advantage of compound interest. Again, the earlier you start, the better your financial future will be.
When it comes to compound interest, time is the biggest advantage you will ever have. When you start early, your money has more time to grow and benefit from compound interest.
It does not matter how much you invest, you should invest regularly. The important thing is to just start and then stick to it. Even the seemingly small contributions you make every month have the potential to grow.
Plus, you can increase your contributions as your financial situation changes throughout your life. Our main goal, however, is to make a habit out of contributing to compound interest.
Don’t Take Money Out
Compound interest means you will be playing the long game. As your savings grow and you earn more returns, you will be tempted to take your money out.
It is important to remember your end goal in times like these. You want to build a financially secure future for yourself and your loved ones. To do that, you will need to build your wealth.
That can’t be done if you keep on spending money.
Therefore, save early and save often. Be patient. This way, you will be able to reach your financial goals more quickly. You will be able to retire early and build a safety net for those you love as well.
What could be better than that? Certainly, all these advantages require some sort of sacrifice. For most of us, that sacrifice comes in the form of being patient with our money and not letting short-term pleasures take control.
Further reading: 5 Easy Money-Saving Challenges That Really Work in 2021
Without Any Prior Experience, Financial Knowledge, or Needing a Huge Budget, And Best of All, Doing It From Anywhere.
How to Take Advantage of Compound Interest
Before I teach you how to calculate compound interest, you need to understand a few things. There are a few key factors that go into calculating compound interest. Each factor plays its role in the final product or amount.
Some factors affect your returns drastically while others don’t. Below are the five most important factors that affect compound interest:
- Interest. This is the interest rate you earn or are charged. The higher the interest rate, the more money you will earn or owe.
- Duration. How long do you think will it take to pay off a loan? The longer it takes you to pay off a debt, the longer it has to compound, and the more money you will owe. Similarly, the longer you leave money in a savings account, the longer it has to grow, and the more money you will have.
- Deposits and withdrawal. Can you make regular deposits to your account? How often will you make loan payments? The pace at which you build up your initial balance or pay down a loan makes a big difference in the long run.
- Frequency of compounding. Interest is compounded daily, monthly, quarterly, or annually. This pace determines how rapidly your balance grows. When taking out a loan or opening a savings account, make sure you understand how frequently interest compounds.
- Starting principal. How much initial capital do you have? How big of a loan did you take out? Compounding adds over time, but the initial amount you borrow or deposit plays a role as well.
With that said, let’s get down to the real business: calculating compound interest.
How to Calculate Compound Interest
The easiest way to do that is to use an online calculator. But if you want to do it yourself, here’s the formula:
A = P (1 + [r / n]) ^ nt
A is the amount of money accumulated after n years, including interest.
P is the initial deposit
r is the annual rate of interest
n is the number of times the interest is compounded annually
t is the number of years or the time the amount is deposited for
It will improve your money-saving skills and have a better insight into how much cash you have saved in the past weeks/months.
The Bottom Line
Compound interest is a great way to grow your money. Not only do you grow your money, but compounding is also a powerful motivator to pay off your debts as soon as you can.
At the end of the day, I want you to utilize all the best methods to flourish financially. I want you to enter your retirement years on your terms and live the life you want.
If you enjoyed this article on The Magic of Compound Interest has any questions for me, please feel free to leave them in the comment section below!
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