The Power of Compound Interest: How Time and Consistency Can Build Wealth
We all know the value of a dollar, right? But have you ever considered the long-term, compounded effects of keeping your money invested over time? Compound interest has a tremendous power to help you amass significant wealth, but are you taking advantage of it? In this article, we’ll look at the power of compound interest, analyze how it works, and help you get started on the path to building wealth.
What is Compound Interest?
Let’s start by decoding exactly what compound interest really is. Put simply, compound interest is the additional interest you earn not only on your original deposit, but also on the accumulated interest from that original deposit.
For example, if you deposit $100 at 10% compound interest, then at the end of the year you’ll not just earn $10 in interest, but the interest earned on the initial balance PLUS the interest earned during the year. Your new balance would be $110 ($100 initial + $10 interest). Now, that original $10 interest is earning a 10% return, so you’ll be making 10% on $110. That’s the power of compound interest!
Why is Compound Interest so Powerful?
Compound interest is a powerful mechanism not merely because you are earning interest on interest, but also because of the dramatic effect it can have over time. To put this in perspective, let’s take a look at two scenarios – one without compound interest and the other with compound interest.
So, if you deposit $100 at 10% non-compounded interest, then at the end of the year you will earn $10 in interest and your balance will be $110. If you keep the balance in the same account, then at the end of the second year you’ll earn a further $10 in interest, your balance will be $120 and your total compensation will be $20.
Now, let’s take a look at the same account with 10% compound interest. At the end of the first year, you will have earned the same $10 in interest and your balance will be the same $110. However, at the end of the second year you will earn $11 in interest (the previously earned $10 plus the 10% on that additional $10). In addition, your total compensation at the end of the second year will now be $21 ($10 initial + $11 interest).
The Difference Compound Interest Makes over Time
This small difference between compounded and non-compounded interest can add up to big money when compounded over the long-term. To illustrate the how compound interest works over time, let’s further analyze each option:
With non-compounded interest, at the end of the third year, you will have earned a further $10 in interest and your balance will be $130. Your total compensation at the end of the third year will be $30.
With compound interest, at the end of the third year, you will have earned a further $12.10 in interest and your balance will be the same $130. However, your total compensation at the end of the third year would now be $32.10 ($10 initial + $11 interest(year 1) + $12.10 interest (year 2+3)).
As you can see, the effect of compound interest only gets bigger when you take into consideration more years. After 10 years without compound interest, your total compensation will be $100 ($10 initial + $90 interest). With compound interest, at the end of the same 10 year period, your total compensation would now be $146.25 ($10 initial + $95.25 interest).
Compound Interest & Investing: How to Get Started
Now that we’ve seen the power of compound interest, let’s talk about investing. The idea behind investing is simple – put your money in stocks and bonds that pay regular dividends and wait for them to appreciate in value. As your investments become more valuable, you’ll earn interest on the new balance.
It’s also a smart strategy to reinvest your dividends so that they can compound even more. Over time, you’ll have a larger pool of money generating more dividends, which compounds even faster.
To get started, research different asset classes and identify those that meet your needs and goals. If you prefer to manage your own investments, you can use an online broker like E*TRADE or Robinhood to purchase stocks and bonds. Or, you can choose to invest in mutual funds and exchange-traded funds (ETFs), which are professionally managed by financial advisors who handle all of the required paperwork and make any needed trades.
You should also speak with a financial advisor to create a plan for your investments, as well as a monitoring strategy to ensure that you stay on track. As you research investments, be sure to examine their minimum investment amount and annual fees, to determine which ones work best for you.
When To Expect Results From Compound Interest
As we’ve discussed, the power of compound interest isn’t seen right away. To reap the benefits of compounding, you need to invest consistently and stay invested. The sooner you start investing and the more often you invest, the larger your future returns will be.
Finally, factor in inflation to get an idea of how much interests rates will actually increase over time. If you try to invest at the highest possible interest rate, you’ll actually be running the risk of stunting your returns. While it might feel great to make 10% on your money, inflation will eat away at that return over time. You’ll be better off reinvesting at a rate just above the inflation rate so that your future returns are worth more than what you invested.
Compound interest is an incredibly powerful wealth-building tool that can help you achieve your financial goals. As long as you understand how compounding works and how to invest wisely, you can start taking advantage of the power of compound interest. Invest consistently, factor in inflation, and stay invested for the long-term to turn insignificant contributions into significant wealth.
