Compound interest is a financial superpower that can make a person rich or keep them poor. Einstein once said “He who understands it earns it… he who doesn’t… pays it.” Simply put, compound interest turns money into more money. Over time, a small amount can grow into a significantly large sum.
Here is a simple example of how compound interest works: You invest $200 in a fund earning 5%. After the first year, you earn $10, the next year you earn interest off the higher $210 balance, which comes to $10.50. The year after that your earned interest increases to $11.03. The money compounds and earns more interest every year. The rate of growth rises at a steady and rapid rate.
What Makes Compound Interest so Powerful?
The compounding of interest is what makes it so powerful. Small amounts start to grow and turn into larger amounts. Large amounts grow into even larger amounts and so forth. Those that understand it will use it to their advantage and start investing early. Those that don’t understand it typically fall prey to banks and end up paying interest most of their lives. You don’t have to be a millionaire to benefit from compound interest. You can benefit right away with just a small amount. Take a look at the chart below, it helps demonstrate the power of compound interest.
Initial balance of $5,000 with interest compounded annually
Interest will compound at different intervals. Annually, semi-annually, quarterly, monthly, daily, and even continuously. Different financial products and loans have variations of when interest is accrued. Once interest is credited or added to an account balance, it begins to earn additional interest. An investor benefits from recurring compounding of interest while a borrower will suffer. Compounding interest for a borrower makes it harder to pay down the balance of the loan. High interest and more frequent rates of compounding make the repayment cost of a loan much higher.
Ways That You Can Earn Compound Interest
If you stuff money into a savings account, you can begin to earn interest. Unfortunately, the interest rates paid by banks are very low. Because of the low rates, saving accounts are not a popular choice to earn compound interest. However, online savings accounts and money market accounts will have slightly better interest rates than a traditional savings account.
Term Deposits (CD’s)
Certificates of deposit or term deposits are another bank product that can help grow your money. They have a higher interest rate than a savings or money market account. Your funds will be harder to access since it will be locked into a specific term (typically 6 months to 5 years).
The Stock Market
The most popular way of earning compound interest is to invest in the stock market. The stock market is capable of producing much higher rates of return. Retirement accounts such as IRAs and 401ks take advantage of earning interest from stock market returns and dividends. With higher returns comes higher risks. Those that chase uncommonly high returns or dividend yields usually end up losing more than those who invest in balanced index funds.
The sooner you can start saving, investing, and earning interest, the better. The longer your money can sit and compound, the wealthier you will become. Putting off saving and investing until you are older can take a significant chunk out of your earnings. Starting at a young age will put you ahead financially in the long term.
Earning interest means you will pay taxes. Using tax-advantaged investment products and retirement accounts can help reduce your tax liability. Even with the cost of taxes, you can still build wealth through compounding interest.
It is almost always better to pay off your debt first before investing. The exception is if you’re able to make more from investing than the amount saved by paying off debt.
Consumer debt, long-term mortgages, and auto loans can put you on the wrong side of compound interest. Don’t pay interest, earn it.