What Is Compound Interest?

You’ve probably heard you should start investing as soon as possible, but why? There are many reasons why you should start investing at a young age. One of the most important reasons is compound interest or what some call the eighth wonder of the world. So, what is compound interest and why is it so important?

What Is Compound Interest?

Compound interest is the additional interest added to the principal amount of a deposit or a loan. It can also be defined by interest on interest. Compound interest allows your money to grow exponentially compared to simple interest. With compound interest, the interest is reinvested and continues to grow.

For example, let’s say you have a $1,000 deposit that earns 5% interest. If the 5% interest compounds annually, you will have $1,050 by the end of the year. Then after the second year, you would have $1,102.50. If you were to receive simple interest, you would only have $1,100 after two years.

The Rule of 72

Calculating compound interest may seem confusing. However, the Rule of 72 can help you estimate the growth of your investment. As long as you know the interest rate on your investment, you can calculate how long it will take you to double your deposit. Simply divide 72 by the projected interest rate and you will have the number of years it will take your investment to double in value.

If you use the example above, it would take about 14.4 years for the deposit to double. You would divide 72 by 5 and get 14.4.

How Compound Interest Adds Value

Helping your money grow isn’t the only value that compound interest adds. There are several other reasons why compound interest is powerful. Here are a few other reasons why compound interest can be valuable to your investment strategy.

Compound Interest Utilizes the Power of Momentum

Imagine an avalanche. It starts with a small amount of snow and then gradually builds as it soars down the mountain. After it builds up enough momentum, the snow mass becomes gigantic and can take out anything in its path.

Compound interest acts in the same manner. It takes some time and effort to build up at first and then it begins to rapidly grow. Once your wealth is built, it begins to attract more wealth.

Compound Interest Can Help the Wealthy and the Poor

When it comes to compound interest, your financial situation doesn’t matter. It crushes the myth that the average person doesn’t have enough to invest in the stock market. Anyone with any amount of money can invest and earn compound interest.

For example, let’s say you make $40,000 a year and decide to invest 10% of your income annually. If you’re consistent, you will have $798,540.45 after 40 years, assuming 7% interest. Keep in mind, this example is the best-case scenario.

Compound Interest Rewards Discipline

Life happens, and you may be tempted to use your savings toward other financial goals. Maybe you want to use your savings to pay for your next family vacation or a new luxury car. However, compound interest rewards investors for staying consistent and being disciplined.

So, when you think about pulling your money out of your savings, think again. Compound interest works best when you consistently contribute to your accounts over time.

Compound Interest Teaches Patience

The media and financial experts will always have opinions of the happenings within the market. These opinions cause investors to make irrational investing decisions or try to time the market. The market is massive and has many factors that make it almost impossible to do so. That’s why consistently investing over time may be one of the best strategies for creating long-term wealth.

Creating wealth doesn’t happen overnight. But by staying the course, you will be able to reap the benefits in the future.

Compound Interest Gives You Peace of Mind

There are only so many hours in a day. With compound interest, you can earn money as you sleep. As long as your investment continues to pay interest, you will continue to earn money.

All you have to do is continue to invest and watch your money grow. Isn’t that a great feeling knowing you can make money all hours of the day and night?

Compound Interest Separates the Financially Secure from the Broke

If you’ve ever had high-interest credit card debt, did you notice the balance decrease once a payment was made? Often, if your balance is large enough, your credit card balance may have even increased.

High-interest debt uses compound interest against you. If you’re making minimum payments, it can be challenging to repay your debt. You’re essentially fighting an uphill battle.

Instead of fighting against wealth, create positive financial habits to help you achieve wealth. If you continue to have poor financial habits, you will continue to fight interest and may never become wealthy.

That’s why you should use compound interest to your advantage and create an abundant financial future.

Why Is Compound Interest Important to Understand?

Now that you understand how beneficial compound interest can be, it’s important to utilize it. It doesn’t matter how much money you have to start, you want to begin investing today.

If one of your financial goals is to save for retirement, utilizing compound interest may be one of the best ways to achieve this goal. If you decide to stash your money under your mattress, you may not be able to reach this goal as fast or even at all.

Whether you open a high yield savings account or an investment account, start contributing to an investment in your future. The earlier you start, the more time you have to grow your money.

Keep in mind, you don’t have to be a millionaire to use compound interest. Any investor has the opportunity to earn interest on interest.

The Bottom Line

If you haven’t started investing, it’s time to start. Whether you don’t feel as though you have enough capital, take whatever you have and start contributing toward your future. You don’t want to miss out on the opportunity to earn compound interest early in your life.

Even if you only have $50 to start, make a deposit and start earning compound interest today!

What’s holding you back from investing? What are some of your long-term savings goals compound interest could help you achieve?

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