Compound interest is the cornerstone of successful investing. But what is compound interest? Compounding occurs when you invest your money and, instead of withdrawing the interest you earn, you reinvest it. By doing so, you not only earn interest on your initial investment but also on the interest generated in previous periods. This powerful process multiplies your returns over time.
Example:
Consider having $10,000, and your intention is to invest it and let it grow over a span of 20 years. Assuming you earn a 10% interest rate annually, and you withdraw the interest every year. In this scenario, you would receive $1,000 each year. So, how much would you have accumulated by the end of the 20-year period? You’d start with your initial $10,000 and add the $1,000 earned each year for 20 years, resulting in a total of $30,000.
Now, let’s consider the same scenario but with compounding in play. Here’s how it works: After you earn your initial interest of $1,000, you reinvest that money along with your initial $10,000, resulting in a new deposit of $11,000. Consequently, the interest you earn in the next period will be 10% of $11,000, which equals $1,100.
So, in the next period, your total will be $11,000 + $1,100, totaling $12,100, and the interest for that period will be 10% of $12,100, which amounts to $1,210.
You repeat this process for all 20 years, and by the end of that period, you will have accumulated $67,275.
Each year, you’ll notice that the interest you earn isn’t stagnant; it grows, and this growth is due to the compounding effect. It accelerates so rapidly that after 20 years, instead of merely earning $1,000 on your initial investment, you’ll be earning $6,115 and so on it goes. The remarkable thing is, you didn’t have to put in any extra effort; you simply let that interest accumulate and grow. Without compounding, you’d only end up with $30,000, but with compounding, your total would reach $67,275.
The longer you leave your money invested, the more time it has to benefit from compound interest. Compound interest tends to have a more significant impact over extended periods.
Investments can compound at different intervals, such as annually, semi-annually, quarterly, or even daily. The more frequent the compounding, the faster your wealth can grow.
Compound interest is a compelling reason to start investing early and to remain invested for the long term. It rewards patience and consistent contributions to your investment portfolio. It is a key factor in building wealth and achieving financial goals over time.
Numerous online compound interest rate calculators are available, and the Securities and Exchange Commission (SEC) also provides its own version. Here is the link