Compound Interest is that magical little secret behind having your money ‘work for you’ over time. If you put money into an investment, and it increases in value, you can measure that change as interest, expressed as a percentage. Let’s say you invested $1,000, and it grew to $1,100. To calculate the interest, simply divide the growth by the original amount and then convert to %.
$100/$1,000 = 0.1 or 10%
As your initial investment earns interest, your money will continue to grow. And as long as it all stays invested, YOUR INTEREST EARNS INTEREST. It’s pretty incredible. That is the Compounding part of this. Think of it as a snowball that rolls down a hill and the bigger the snowball gets, the more snow it picks up.
The two factors needed to experience the power of Compound Interest are:
- Rate of Return
Compound Interest: Time Example
Let’s look at a time example and compare what would happen to an initial $5,000 investment left to grow for 5 to 30 years, assuming an 8% return. The results show the importance of investing for the long-term, the same initial investment results in seven times more money if you just left it alone to grow.
Compound Interest: Rate of Return Example
Now let’s compare what would happen to the same $5,000 investment if left to grow for 30+ years but change the Rate of Return.
The green line represents the projected growth of your initial investment based on an 8% return, a historical average benchmark often used for stocks. In comparison to more conservative investments (4% or less) like savings accounts and bonds, which have a lower rate of return, you can see the impact of Compound Interest over the years.
- Although Savings accounts and bonds do have a place in many people’s portfolios, they are not there to accumulate wealth because of their low rate of return.
- The time to invest is as soon as it is appropriate for your situation. Since Compound Interest takes time, it is beneficial to get the clock ticking sooner rather than later.
Compound interest is vital to maximize the growth of the money you invest over time. However, if you don’t invest sufficient amounts of money, you will still not reach your long-term financial goals. That is where your Savings Rate will come into play. Check out my Compound Interest Calculator for yourself! I believe it is the best one on the internet. And if not, it is definitely the best one on my website. Enjoy!