The magic of compound interest

Will you give up something today to get something better tomorrow? It is an age-old question that we all face on a regular basis. It is also the key to a financial concept known as compound interest. Let’s talk about some of the what you need to know about compound interest.

What is compound interest?

It’s just earning interest today on the interest you earned yesterday. If you took out $ 100 a year ago and received $ 2 in interest, now you would have $ 102 in interest. The interest you will earn on the $ 2 this year is compound interest. It’s money that replaces itself!

What Can Compound Interest Do?

While a lot of people know what compound interest is, they don’t know how powerful it can be. Taken over a short period of time, compound interest isn’t very impressive. How about earning interest on two more dollars?

It might not matter for a year, but if your money is piling up for decades, it can make a huge difference. Especially if you earn more than 2% on your investments (and I hope you do!)

For example, if you take the long-term return of the S&P 500 at 10%, your money would double every seven years. So your $ 100 today would be $ 200 without you adding a dime in just seven years. Or $ 400 in 14 years. Or $ 800 over 21 years. The power of composition is clear.

Why aren’t more people taking advantage of compound interest?

Perhaps this is because many do not understand the power of compound interest. Or they don’t realize how quickly time flies.

When you are in your twenties or thirties, retirement seems far away. When you are between 40 and 50, it seems like it’s too late to take advantage of compound interest. Neither is true. If you’re young, you’ll be 60 before you know it. And, if you are nearing retirement, know that if you enjoy an average longevity, you will live well to 80 years.

There is also the issue of deferred gratification. For most of us, it’s hard to let go of something we want today and get something better years from now. But that’s what compound interest requires. You have to forget about that new flat screen today to have the money compounded into your IRA for retirement later.

The power of compound interest

Suppose you invested $ 1,000 and were able to earn 9%. You have never added to the account. In just 10 years, it would be worth $ 2,367, in 20 years $ 5,604 and $ 13,268 in 30 years. Imagine what it would do if you regularly added to the account.

Anyone can benefit from compound interest

You don’t have to be a big investor to take advantage of compound interest. It works just as well on the first dollar you invest as it does on a million dollar portfolio. In fact, compound interest is a great tool for reaching that million dollar portfolio.

The dangers of compound interest

Compound interest is a double-edged sword. It’s a wonderful tool, but if you don’t use it properly, it will do a lot of damage.

How? ‘Or’ What? Credit card debt is a prime example. Instead of earning interest on the interest, when you owe the credit card company, you pay interest on the interest. Thus, the amount you owe keeps increasing. This is one of the reasons they are happy that customers make the minimum payment each month and often increase your credit limit if you get close to it.

Remember that $ 1,000 we invested a moment ago. Suppose you borrowed it instead. On your credit card. And you paid a typical rate of 15 percent. You will need $ 150 just to pay the interest this year. If you keep this balance for 10 years, you will pay $ 1,500 in interest. To borrow only $ 1,000!

The bottom line of compound interest

The difference between continually worrying about money and living a comfortable life may not be as big as you think. Simply switching from paying compound interest on your debt to accumulating compound interest on your assets can cost as little as a few dollars each month.

Whether you are an active trader or the type of investor who buys and keeps average dollar costs, the sooner you start using compound interest, the more powerful it will be.

© 2021 Benzinga does not provide investment advice. All rights reserved.

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