By MoneyWise Staff
Wednesday, February 19, 2020
Compound interest has been called the 8th Wonder of the World. It can be a double-edged sword, benefiting those who use it to build wealth, and burdening those who accrue interest on loans and dig themselves into deep financial holes. Let’s discuss the basics of compound interest and the effect it has on your financial future.
What is compound interest and how does it work?
Compound interest is interest calculated on an amount of principal (e.g., a deposit or loan) including all accumulated interest from prior compounding periods. Put more simply, it is interest on top of the interest previously added to the principal. Compound interest causes principal to grow exponentially over time. In the case of invested assets, it is a powerful tool to build wealth.
Examples of how compound interest can help build wealth:
Warren recognized early in life that if he routinely saved and invested, he could accumulate wealth and live a better life. He started investing at 22, adding $500 per month to an account which held an index fund tied to the stock market. The index fund returned 7% per year for the next 40 years, when Warren retired at the age of 62. The initial $500, and the monthly contributions thereafter, grew to almost $1.2 million thanks to time, compound interest, and Warren’s investing strategy.
Warren’s friend Charlie wasn’t able to put away as much as Warren during his career, but he invested a $10,000 inheritance at 22 in the same index fund. Charlie’s investment, despite him not adding any more money to it, was worth almost $150,000 when he turned 62. How? Time and compound investment returns caused Charlie’s inheritance to grow without him adding a penny.
From these examples, you can see how remarkable compound interest is and why you would want to take advantage of it whenever possible. However, compound interest also applies to most of your debt like student loans, mortgages and unpaid credit card balances. In my next post I will explain how compound interest can have a negative effect and how you can best avoid it. Here are a few tips on how to get the most out of your money with compound interest.
Don’t just save — invest! To take advantage of compound interest, your savings must be in an account that pays some kind of return on investment. That rate will depend upon the amount of risk taken. Higher rates of return are associated with higher risk of loss, and lower rates of return are associated with lower risk of loss.
Start as early as possible: Time is one of the most important elements of compound interest. The longer your money is invested, the more opportunities it will have to grow. A 25-year-old who puts away $500 a month until age 65 with a 7% rate of return would have nearly $1.2 million, while a 35-year-old doing the same thing would have only $567,000 at age 65. The earliest years of investing are the most important when it comes to compounding.
Be consistent and patient: Consistent contributions to an investment account over time gives compounding more principal to compound on and can enhance returns. As Warren and Charlie discovered, even modest contributions, paired with investment returns over long periods of time, can help you reach your financial goals.
Check it out for yourself: The U.S. Securities and Exchange Commission has a compound interest calculator available on their website. Look at what your savings could look like based on different timeframes and rates of return.
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