How Compound Interest Works and How It Can Help Save You Money

Chances are you’ve heard of the monetary term “compound interest”, but do you know how it really works?

Otherwise, you are in the majority: 69% of Americans do not understand it. It depends ValuePenguin, who asked 2,000 Americans if they could define key financial terms like credit score, net worth and compound interest, and shared the results with CNBC Make It.

It is an important concept to grasp. After all, compound interest can snowball your wealth and save you hundreds of thousands, if not millions of dollars.

What is compound interest?

Compound interest makes a sum of money grow faster than simple interestbecause in addition to generating returns on the money you invest, you also get returns on those returns at the end of each compounding period, which can be daily, monthly, quarterly, or annually.

That’s why compound interest makes your wealth grow faster. This is also why you don’t have to put so much money aside to reach your goals.

Consider the following graphics from NerdWallet. Each indicates how much money you would need to set aside to save $ 1 million at age 67. It assumes you are starting with zero dollars and also assumes various average annual ROIs.

The graphs are very different depending on the age at which you start saving.

Here’s what the road to $ 1 million looks like if you start saving at 25:

If you start saving at age 30, things get a bit tricky:

Here’s another graph of compound interest, which the New York Times journalist and author Ron Lieber says he changed his life.

Published in 1994 by USAA, it shows how much money you will accumulate over time if you invest $ 250 per month from different ages. It assumes an average annual return on investment of 8%.

lieber tweet

The graph shows how much money you will accumulate over time if you invest $ 250 per month from different ages. It assumes an average annual return on investment of 8%.

If you are starting at age:

25: You will accumulate $ 878,570 at age 65

35: You will accumulate $ 375,073 at age 65

45: You will accumulate $ 148,236 at age 65

Compound interest can also work against you when it comes to credit: this means that every year or every month, no matter how frequently your credit is, the amount you have to repay increases.

So the longer you pay off your loan, the more interest you will have to pay.

For example, suppose you have a five-year, $ 20,000 loan with an interest rate of 5% that accumulates each year. A compound interest calculator shows that if you pay it back in three years, you’ll pay $ 3,153 in interest. But if you pay it back over five years, you’ll owe a lot more: $ 5,526.

How to use compound interest to your advantage

The sooner you invest your money, the more compound interest you will earn. So where to invest? The easiest starting point is to contribute to 401 (k), a tax-efficient retirement savings account that many companies offer, or other retirement savings accounts, such as a Roth IRA or traditional IRA.

Many experts, including Warren Buffett, recommend investing in low-cost index funds, which allow you to own a small portion of many different companies. The S&P 500, for example, is a fund that owns shares of the 500 largest companies in the United States, including Apple, Google, Exxon, and Johnson & Johnson.

You can also look for robo-advisers, such as Betterment, Wealthsimple, and Wealthfront. These are automated investment services that use an algorithm to determine the type of portfolio that is right for your age, risk tolerance and time horizon.

Whichever way you choose to invest, the most important step is to open at least one account and start contributing to it on a consistent basis to take full advantage of compound interest. The earlier you start, the better off you’ll be.

Don’t miss: Money expert says this simple 1994 chart changed his life

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