What is compound interest? | Financial literacy
The most powerful force in the investment world is compound interest. In fact, Albert Einstein once called compound interest on “The eighth wonder of the world! “But what is compound interest? Why was it a wonder to one of the brightest minds of the modern age? To understand, it’s best to break the concept down into explanations at a time practices and mathematics.
If you are an investor, you need to know what compound interest is, how it works, and how to earn it. A large portion of your wealth building opportunities come from compound interest. Here’s a crash course on compound interest and how to use it in your plans to build wealth in the future.
The definition of compound interest
Compound interest is the continuous addition of interest payments to the principal balance. This starts a cycle of growth where, every time the interest compounds, it is generated by a higher and higher balance. This is a definition best illustrated by an example.
Consider how much money you would have after 30 days if you start with a dime and double the principal each day. While you would still have only a handful of change at the end of your first week, on day 15 your balance would be $ 163.84. On day 20, it would be $ 5,242.88. And, by day 30, you would have more than $ 5.3 million to show for your composition. This example is one of the best to illustrate the power of compound interest, although it is an extreme example.
The reality is that most interest is made up a few percent at a time, over a longer period of time. For example, the stock you own may pay a dividend of 2.15% each quarter. Or, your index fund can return 9% per year. The key factor in creating wealth in this case is time. The more periods of funding, the more it is added to the principal balance and the higher the next compounded amount.
How to calculate compound interest
For those who prefer a mathematical look at the power of compound interest, there is a specific formula to calculate it: P (1 + r / n)NT. In this formula:
- P = the balance of the initial capital
- r = the interest rate
- m = the number of times the interest is applied
- t = the number of elapsed time periods
By investing standards, this formula is actually very simple. In most cases, the interest rate and the number of times interest applies are fixed, giving investors more control over other variables. You can continue to increase your principal balance over time by reinvesting. And, the longer you let your funds accumulate, the more that balance increases.
Examples of compound growth over time
Many investments offer opportunities for capitalization. This is about recognizing the different options of compounding interest and understanding how much and how often compounding takes place. Here are some basic examples:
- Marcy invests in an S&P 500 index fund for 20 years, with an average return of 7% per year. Her initial balance of $ 5,000 and monthly contribution of $ 250 will have increased to over $ 150,000 when she rechecks it.
- Dalton owns shares of XYZ Company, which pays a quarterly dividend of 2%. Over a five-year period, the stock itself increases by 50%. At the same time, Dalton reinvested dividends, which bought fractions of shares and allowed him to grow his holdings exponentially.
Any investment that adds accumulated gains to capital to enable even more wealth creation is an example of capitalization. Whether it’s stocks, bonds, funds, or some other investment vehicle, the goal is to grow capital through return on investment, to generate even more income.
Want a more comprehensive look at the power of composition? Consult our investment calculator and enter your own investment numbers to see how compound interest affects your accumulation over time.
How to maximize the composition
Whether you use debt or equity securities, or use another mode of investing, there are several ways to maximize its potential. Here are some of the best strategies:
- Time spent invested. The more compound periods there are, the more accumulation per period. Translation: the more you keep building capital, the more money it will bring.
- Ongoing investments. Continuing to invest capital is a powerful way to accelerate accumulation. Not only will the membership increase the return on investment, but the continued contribution to the fund balance will also increase.
- Reinvestment. If your investment pays dividends or offers other reinvestment opportunities, take them! As the principal investment continues, these additional repayments will increase earning capacity.
- Optimal interest rate. The higher the interest rate (or rate of return), the more money from power is added to the balance of capital. Look for investments with a history of high interest rates.
There are dozens of other ways to optimize the mix that are specific to the investment. Look for ways to maximize the variables over which you have control: time, contributions, mode of investment and more.
Composition is the key to building wealth
Albert Einstein also had another quote on compound interest: âhe who understands it wins it; whoever does not pay for it. âThe concept is simple. In investing, compound interest works in your favor. If you’re trapped in debt, every month that goes by makes your debt worse. That’s why it’s so important to understand the makeup. in the context of building wealth.If you’re not on the good side of compound interest, you’ll have to work hard to get there.
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What is compound interest? Apart from a wealth creation tool, it is your guiding force for the security of the future. Taking the time to make smart investments that capitalize on compound interest will give you the peace of mind you need to grow your money. Then it’s just a waiting game as you watch your wealth build up.