What is Compound Interest?

To put it simply, Compound Interest is the interest you earn on interest. It is the result of reinvesting interest so that interest in the next period is then earned on the principal sum plus previously accumulated interest. Below is the formula to calculate compound interest:

Compound interest is calculated by multiplying the principal amount by one plus the annual interest rate raised to the number of compound periods minus one. The total initial amount of the loan is then subtracted from the resulting value.

A quick example:

Say you invest $1,000 and return 10%. Now you have $1,100. To take advantage of the power of compound interest, you decide you’re going to reinvest all $1,100. Once again you earn 10%, and instead of your portfolio gaining another $100, it actually gains $110 this time. That additional $10 is the power of compounding. When investment returns begin to return investments themselves.

History’s most famous scientist once described compound interest as “the 8th wonder of the world, he who understands it, earns it; he who doesn’t, pays it.” Allowing you to earn interest on your interest is the beauty that compound interest has to offer. Initially, yes you must work hard to earn the money that you first invest, but once you invest initially, going forward, your money works for you. In order to get the most of your investments and compound interest, you must:

  1. Reinvest all dividends
  2. Invest over the long term
  3. Keep adding to your initial investment

The longer you do not touch your money/investment, the ability of compounding becomes more effective. If you have the discipline to contribute to your investment on a regular basis and the patience to not withdraw any of it, you can turn the smaller initial investment into a much larger amount.

Calculating Compound Interest:

When calculating compound interest, the number of periods makes all the difference. As you can imagine, more compounding periods, the greater the compounding interest will grow. Also, because compound interest also accounts for the interest that was accumulated from previous compounding periods, the interest amount will not always be the same each year.

That is why the 2 Key Factors for Compound Interest are:

  1. Time
  2. Rate of Return

Imagine you invested $1,000 today with a rate of return of 10% and each month you are going to add $50 to your investment account. Well after 20 years, assuming that you reinvest everything that you earned, to take advantage of the power of compounding. Your account will now be worth $41,092. Imagine doing 40 years, instead of doubling to $82,000, it climbs to $310,814. That is the value of time. The longer time has to work on your investments the more it grows.

The conclusion is, start investing right away. The longer you can invest, the more the power of compounding will work for you. Secondly, try to get a rate of return on your investments to be as high as possible without being too risky.

One side note, you want to keep an eye on any fees you’re being charged depending on how you’re investing. Investing in ETFs, Mutual Funds, or utilizing a Money Manager can eat away at your compound interest as these choices will be charging a fee of anywhere around 1%. Investors should really keep an eye on the expense ratios and management fees they’re giving up when allowing other people and institutions to manage their money. It can sometimes be a difference of hundreds of thousands of dollars when looking at it from a compound interest perspective.

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