Anyone looking to make money off an investment should be aware of compound interest. Compound interest is the interest on a loan or deposit calculated based on the initial principal and the accumulated interest. It can also be considered “Interest on interest” as it makes a money grow faster than simple interest.
This article will take a closer look at compounding interest and provide examples of people that have become wealthy by letting their money grow.
Related post: How to Save Up Your First Million Dollars
What is Compound Interest?
Compound interest includes any interest on the initial principle as well as all accumulated interest from previous periods. It is calculated by multiplying the initial principle amount by one plus the annual interest rate raised to the number of compound periods minus one.
The interest can be compounded on any schedule from daily to annual. The number of compounding periods will make a significant difference in the total interest amount.
Now, I know that sounds confusing, and it may take an expert to figure out exactly how much compound interest you can expect to make, but let’s try to use a realistic example to give you a better idea of how it works.
Let’s say you invest $10,000 at an interest rate of 3% that compounds monthly for 20 years. How much money will you make at the end of those twenty years?
To figure that out, take the $10,000 and consider the combined effect of your interest rate divided by the number of times the interest is compounded per year. (In this case it will be 12).
Now times 12 by 20 to get the total number of times it will compound (in this case 240). Considering the 3% interest rate, you will be left with $18,207.55 at the end of the 20 years or a total gain of $8207.
The numbers sound confusing, so let’s try to put it in plain English. With compound interest, it’s all about letting money grow. As money accumulates interest, the principle, as well as the interest that accumulates will continue to increase by the interest rate. So the longer you leave that investment there, the more money you will make.
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Compound interest investing is a smart move. Here are some examples of people that were able to grow wealth using this method.
Financial expert Caroline Lupini was lucky to have parents that taught her how to take advantage of compound interest at a young age. She advises investors that the main things that contribute to big interest payouts are the principal amount, the interest rate, and the number of times the interest is compounded.
She notes that the number of times the interest compounds is more important than the rate since that is what sets the exponent mathematical relationship. Therefore, she tries to invest as much as possible in high yield saving accounts and stock portfolios and leaves her money there as long as possible. She knows the more time the interest has to compound, the greater return she is likely to make.
Jack and Blake
Jack and Blake are a couple of teenagers Dave Ramsey uses as an example of how people can get rich through compound interest.
Jack started investing when he was 21 years old putting $200 away every year for nine years. By the time he was 30, he stopped investing.
Blake started investing $200 a month at age 30. Even though he started later than his friend, he kept his money in longer. In fact, he let the account build until he was 67 years old.
When Blake pulled his money out, it had accumulated to $1,483,033. And while that’s not too shabby, Jack’s return was $2,547,150, quite a bit more.
Jen Glantz, writer at BusinessInsider.com found out about compound interest later in life, but once she did, she was able to take advantage of all it had to offer.
She started by taking money out of her savings account that had a .03% interest rate and putting it in a high yield saving account that offered 1.7% interest. That way, every time the money compounded, it would give her even bigger returns.
Then she opened a high interest CD that compounded daily. She was able to take advantage of the higher interest rates as well as the frequency at which the money earned interest.
She also reconsidered the financial strategy she was taking with her retirement account. Originally, she would only make a deposit into the account once a year. She switched tactics making more monthly contributions knowing it would earn her more interest. Another bonus was that the interest she earned on her SEP IRA account was tax deferred.
Tips for Smart Compound Investing
If you are interested in growing your wealth with compound investing, here are some useful tips.
Start by Focusing on Saving: Although financial experts say that the interest rate and how often the money compounds are more important than the investment itself, in the early years, building up your savings will be key. Live frugally and budget accordingly so you can begin squirreling away savings on a monthly basis. Focus on building a nest egg rather then trying to find the right investments.
Be Patient: The more often your interest compounds, the more money you’ll be making. Therefore, it’s smart to leave money in your accounts as opposed to pulling it out because you’re frustrated by low returns. It may take a while, sometimes as much as 25 years, but over time, you will see your money grow.
Invest in Yourself: The more money you have to invest, the more it will grow. Therefore, you will also want to invest in yourself gaining skills and training that can qualify you for higher paying jobs. You can use the extra pay to make bigger deposits into your account that will make even more interest.
When Compound Interest is Bad
For the most part, when it comes to compound interest, you can’t go wrong…except when you’re paying off an account that accumulates compound interest.
Take, for instance, your credit card.
Your credit card has an interest rate that makes your payments higher. Not only does it accumulate interest, it tacks interest onto that interest so that you owe more and more each month.
The best way to avoid this negative compound interest is to make a payment each month that is big enough to keep interest under control. Better yet, pay off credit cards immediately or avoid using them altogether.
Compound interest is a great way to accumulate wealth. Be smart with your money and make the right investments to get it to work for you. Good luck watching those number grow.
Research for this article was sourced from the following:
- MoneySense: How to use compounding to grow your money fast
- Business Insider: I made 3 changes to my savings strategy after learning about compound interest, and now I’m earning more than ever
- Business Insider: I bought an expensive purse in high school, then my dad showed me how I could have grown that money instead — and I’ve lived by the lesson ever since
- Dave Ramsey: How Teens Can Become Millionaires
- Investopedia: Compound Interest