Most of us would say we work extremely hard for our money. How would you feel about getting your money to work harder for you instead? The “trick” is getting the math of compound interest on your side.
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
– Albert Einstein
Luckily, you don’t need to be a genius like Einstein to figure out how to use compound interest to your advantage.
How Compound Interest Works
Interest is the percentage of the original amount of money – known as the principal – you must pay on a loan or earn on an investment.
Compound interest is the interest calculated on the initial principal plus all the accumulated interest from previous periods on a deposit or loan.
In other words, interest is accumulating on interest.
Whether it is working for you or against you, interest accrues over a specific time stated within the terms and conditions of the account or loan. The compounding period is usually a year. At that point, all the accrued interest is added to the principal, that pot of money combines and becomes larger, and interest begins accumulating against the new combined amount.
A good example of compounding interest that works in your favor is investing in stocks or mutual funds. Each year, the base amount that you are earning interest on grows (usually) as the previous year’s interest gets added to the principal and you earn interest on the whole amount moving forward.
Factors That Create the Compound Effect
There are several factors that determine the compounding effect, but we will exam two of the most important.
- Interest Rate. This is the rate you will earn on your investment. For investments in stocks, this would include dividends and capital gains.
- The more time you allow your money to grow, the more it will compound.
Let us break it down by comparing two real-life options for investing.
Option 1 – Treasury Bonds earning 4%
At age 25, John invests $10,000 today in a treasury bond that earns 4% for the next 20 years. At the end of 20 years, his investment will be worth $21,911. Pretty good.
If John is patient and invests for 50 years instead of just 20 years, then the bond would be worth $71,067. Pretty great!
The big lesson here is that the younger you start investing, the longer the interest can accumulate on your behalf. That interest accumulates at an exponential rate.
Option 2 – Stocks and/or Real Estate earning 12%
If John invested his original $10,000 in something with more risk instead – say stocks and/or real estate – he is rewarded for taking the risk of potentially losing some of the principal investment by earning a much larger 12% rate of return.
In this scenario, John would have $96,463 in that same 20 years. In 50 years, he would have $2,890,022. Amazing!
It is easy to see how a higher interest rate can impact your investments significantly. Pair that higher interest rate with more time, and things start to get exciting.
Finding the Right Balance
At first glance, you might think you would automatically go for the higher interest amount. But with the higher interest comes greater risk of losing those funds. You need to make sure you have an understanding of the risks involved to make sure it is a risk you are willing to take on.
A financial professional can help you understand the potential downsides and create a plan designed specifically for you and your tolerance for risk balanced against the amount of time you have to grow your principal investment.
These examples make it clear that if you are trying to get ahead, it is not enough to simply save money – you must get your money working. By saving first and then developing an investment plan to have your money use the benefits of compounding interest, you can use this eighth wonder of the world to your advantage.
To learn more about how your money can work harder for you, please give me a call at (608) 835-1247 or email me, and let's start the conversation!