When it comes to investing, compound interest is king.
Compound interest is when the interest you earn on an investing or savings account is reinvested, earning you more interest. You basically accelerate the growth of your savings and investments over time. As a wise man once said, “Money makes money. And the money that money makes, makes money.”
Here’s everything you need to know about what Albert Einstein allegedly called the eighth wonder of the world.
Let’s start with a basic example. Say you have $10,000 in a savings account that earns 10% in annual interest (10% per year). Year one, you’d earn $1,000, giving you a new balance of $11,000. Year two, you would earn 10% on the larger balance of $11,000, which is $1,100 —giving you a new balance of $12,100 at the end of year two.
Thanks to the magic formula of compound interest, the growth of your savings account balance would accelerate over time as you earn interest on increasingly larger balances. If you left $10,000 in this hypothetical savings account for 20 years, kept earning a 10% annual interest rate the whole time, and never added another penny to the account, you’d end up with a balance of $67,275.
You can compound your interest or add it back into the initial balance at different time intervals. For instance, interest can be compounded annually, monthly, daily or even continually. The more frequently interest is compounded, the more rapidly your balance grows.
Continuing with the example above, if you started with a savings account balance of $10,000 but the interest you earned compounded daily instead of annually, after 20 years you’d end up with a total balance of $73,870. You would have earned an additional $6,595 from interest being compounded more frequently.
Here’s the compound interest formula:
A = the amount of money accumulated after n years, including interest
P = the principal amount (your initial deposit or your initial credit card balance)
r = the annual rate of interest (as a decimal)
n = the number of times the interest is compounded per year
t = the number of years (time) the amount is deposited for
Compound interest and compounding can explode your savings and retirement potential. Successful compounding allows you to use less of your own money to reach your goals. However, compounding can also work against you, such as when high-interest credit card debt accumulates over time. That's why compounding is a powerful motivator to pay off your debt as soon as possible and start investing and saving early.
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