The Magic of Compound Interest
Personal Finance

The Magic of Compound Interest

Story Highlights
  • Compound interest is one of the most important principles of investing, allowing you to earn interest on your interest.
  • Compound interest can also work against you, as your debt will continue to grow the longer you hold on to it.

Make Your Money Work For You

Compound interest–sometimes referred to as the eighth wonder of the world–is one of the most important principles of investing. This simple concept is what allows investors to start accumulating wealth.

Compound interest is the idea that you earn interest on both the initial investment and the interest that you continue to accumulate on it. In other words, you will begin to earn interest on your interest.

This is what allows your invested money to grow even larger over time, enabling investments to accumulate more and more value the longer you hold onto them. You can use the TipRanks’ compound interest calculator to better understand how this works with real numbers.

Compound Interest in Simple Words

Investing revolves around a straightforward proposition: you trade present-day liquidity for a future pay-out, with the potential reward directly related to the amount of risk you are willing to take.

Investments come in all types of shapes and sizes, from savings accounts, the stock market, or even your cousin’s start-up. The idea behind compound interest is relevant to them all.

For instance, investing $1,000 in a savings account that is bearing 6% annual interest will net you $1,060 after the end of the first year. However, if you keep your money in the same savings account for another year, you will receive a 6.0% return on the $1,060. That $60 you have gained will now also start to earn money. Assuming the interest rate remains the same, by the end of year two you will now have $1,123.60.

While the gains are not overwhelming at first, if you keep your money in the account for 10 years, your investment will have ballooned to $1,790.85. After 12 years, your initial investment of $1,000 will have more than doubled in value.

This example assumes that your account compounds interest on an annual basis. If the compounding takes place at a higher frequency, you will enjoy even greater benefits. Use the TipRanks’ compound interest calculator to better understand how changing the frequency of the compounding timeframes will impact your earnings.

The Snowball Effect of Compound Interest

The same principle that works for a savings account has relevance for all types of investments.

Keeping your money invested in good investments allows your wealth to continue growing at increasingly better rates. Re-investing dividends earned in the stock market will allow you to acquire larger holdings. Keeping your money in your cousin’s start-up will allow the business to continue growing by finding new markets or product lines.

It all comes back to the initial trade-off: short-term liquidity for long-term wealth. As your pot of money expands, continuing to re-invest this money allows you to grow your wealth at increasingly higher rates.

The Flip Side: The Debt Cycle

It is important to understand the idea behind compound interest due to its potential to help you increase your wealth. But it is also important to understand why it can keep you underwater.

Just as your investments will continue to grow over time, financing your debt is not cost-free. The longer you remain in debt, the more difficult it is to escape this vicious cycle.

Credit card debt is especially hard to beat. Most credit card companies compound debt on a daily basis, meaning that it can quickly grow much larger than your initial expenditure. This is why it is essential that you understand not just the amount of your debt, but the interest rates you are being charged. This will help you identify which debts are growing the fastest, and which ones are most pressing to pay off first.

Conclusion: Growing Your Financial IQ

Understanding the idea of compound interest can enable you to make more strategic decisions for how to increase your wealth.

The TipRanks’ compound interest calculator is a useful tool to help you become familiar with this concept. You can plug-in different numbers, interest rates, and compounding frequencies to learn how these different parameters impact the growth of your investment.

Considering compound interest will allow you to maximize the rate of return on your investment. It is a trick the wealthiest and most successful investors use to grow richer. You should should take advantage of it as well.

Learn money management, and use data-driven stock insights with TipRanks.


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