Save Early, Save Often: Building Wealth with Compound Interest
“Interest” has many uses in finances—and many uses work in your favor. For example, earning interest can help improve your overall net worth. In fact, compound interest (sometimes also called compounding interest) is one of the most powerful tools available to build wealth.
What is compound interest?
Compound interest is the process of adding interest on the principal balance and interest you’ve already earned. It works like a snowball rolling down a hill, accumulating more and more on the original amount.
This is why compound interest can help your savings or investments grow more quickly as time goes on. For example, if you save $100 per month from ages 25 to 55 in a 4% high-yield savings account with compound interest, your savings would be nearly $70,000!
Examples of accounts and investment options that allow you to take advantage of compound interest include:
- Savings accounts
- Certificates of deposit (CDs)
- Money market accounts
- Savings bonds
- Dividend stocks
Make compound interest work for you
The most important tool for compound interest is time. The sooner you begin saving or investing, the more time you will have to reap the benefits. What’s more, if you save or invest a small amount every month, compound interest can make your total grow even faster.
The easiest way to use compound interest to your benefit is to combine three actions:
- Open a compound interest-bearing savings account as early as possible
- Avoid making any withdrawals
- Add to it every month, even if it stretches your budget
The math of compound interest
In a nutshell, compound interest means earning interest on your interest — and in the case of an investment, a return on your returns. Your rate of return applies both to the original investment (or “principal”) and to previous returns — the money you’ve earned in interest payments to date. Essentially, your money is going to work for you. Below is a breakdown of how compound interest can look:
You invest $1,000 in an account that earns compound interest at a 5% annual rate of return.
At the end of the first year:
You will have earned an extra $50 on the original invested amount.
$1,000 + (.05 x $1,000) = $1,050
At the end of the second year (if you make no additional contributions):
You will have earned on the new balance.
$1,050 + (.05 x $1,050) = $1,102.50
The 5% rate of return stays the same, but the amount you earn on top of your original $1,000 investment increases — or “compounds” — each year.
Turbo charge your savings with compound interest
In the example above, an additional $50 earned the first year and $52.50 earned the second year may not look like a large gain. But the longer your money stays invested, and the larger the contributions are, the more profoundly it will increase.
Continuing the example above with a $1,000 initial investment compounding at a rate of 5% per year:
Keep in mind that in this example, the $1,000 principal is the only money that you contributed into the account. If you were to contribute as little as an additional $100 into the above compound interest-bearing account each month, after 10 years, you would have $17,128 (if you make no withdrawals from the account).
The flip side of compound interest: compound debt
Compound interest can boost your savings and investments, but it’s important to understand the other side of this concept as it applies to debt. While compound interest increases the amount you earn, the same is true for the amount you owe on a loan with a compound interest rate.
Mortgages and auto loans generally charge simple interest, where the loan balance decreases by the same amount for each interest period. But credit cards, student loans and other personal loans typically charge compound interest. The longer you take to pay off those balances, the more you will pay in interest to the lender. Alternatively, the sooner you can reduce your debt and start earning interest on your savings, the more you can leverage compound interest to work on your behalf.
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