How compound interest can change your life–really!
Nobel Prize winner and renowned physicist Albert Einstein is rumored to have called compound interest the eighth wonder of the world. Regardless of whether he said it or not, it might actually be true, at least in the mathematical world. Compound interest is a powerful income-generating, wealth-building tool that can substantially impact your financial future.
If you don’t know what compounding interest is, or better yet, how it works, don’t worry—you’re in good company. According to ValuePenguin, who asked 2,000 Americans if they could accurately define some financial terms like net worth, credit score, and compound interest, nearly 70 percent of Americans had to ask Siri for help. Let’s see if we can fix that.
Simple vs. compound interest
There are two different types of interest: simple and compound. Simple interest is interest earned on only the principal amount of your investment. Consider a certificate of deposit (CD), for example. At the end of the term, you’ll receive your initial investment amount plus a fixed amount of interest.
Compound interest, on the other hand, is interest earned on interest, and it’s the quickest way to bump up your balance. Each period’s interest (daily, monthly, quarterly, or annually) is earned on the initial amount of your investment plus all the previously accumulated interest.
Here’s an example:
If you invest $10,000 at 7% simple interest, $700 in interest will be added to your account after Year 1. In Year 2, another $700 in interest will be paid to your account… and again in Year 3, Year 4, and so on. As long as the interest rate remains the same, you can count on earning the same $700 amount year after year.
If your $10,000 investment paid 7% compound interest, you’d see the same $700 interest in your account after the first year. However, in Year 2, your interest will be calculated on the new balance of $10,700, not your original investment of $10,000. The interest payment for Year 2 will be $749, which is then added to the $10,700 in order to calculate the interest for Year 3, and so on.
The effect of compound interest is extraordinary. At 7% simple interest, your $10,000 investment would be worth $27,500 after 25 years. With compound interest, the value would have grown to more than $50,000. It’s easy to see which one puts your money to work, and makes the biggest difference.
Invest sooner than later
You don’t need to be a mathematical whiz to benefit from compounding interest.
When you’re saving or investing money, compound interest will continually give you a financial boost. The more time your investment has to run the cycle of earning interest, adding it to the investment balance, and then earning interest on the new balance, the better. Want to see how much a specific investment amount could grow with compound interest? Check out this compound interest calculator.
Put your money to work
Compound interest works the same way, regardless of the amount of money you invest, and it adds up faster than you think. At 6 percent compound interest, your money should double in about 12 years and be worth four times as much in 24 years–that’s the Rule of 72. Simply take the interest rate and divide it into the number 72, which will estimate the number of years it will take for your money to double in any one investment.
Compounding interest can be an important component of your overall financial strategy. It’s ideal for investors with longer time horizons, but it also works for investors who’ve gotten a late start saving for their future. Whatever your situation, don’t wait another day. Put your money to work now and take advantage of the power of compounding.