Compound interest: the eighth wonder of the world. Most people ‘discount’ it – especially when it comes to their own finances – but, the truth is, compound interest is still the most powerful way to grow your money.
In fact, it’s the best factor to understand if you’re looking to build long-term wealth.
In this article, we’ll cover compound interest, its advantages, & how to get started.
1. Compound interest allows your money to grow exponentially.
Although this sounds, at first glance, like a financial scheme, compound interest is one of the few things that actually works. When you allow your money to grow through compound interest, it increases at an increasingly accelerated rate. Over time, this can make a massive difference in your wealth.
For example, if you invested $10,000 at a rate of 8% and left it untouched for 20 years, it would grow to more than $46,000. This is because the interest you earn each year is added to your original investment – your investment earns interest on its interest.
2. Compound interest can help you achieve your financial goals quicker.
Let’s face it; no one ever got rich by putting their money into a low-interest savings account, unless they were born into a wealthy family. To grow your money, you need to invest it, despite the risk. And the sooner you start investing, the better.
Thanks to compound interest, your money starts working for you right away – literally the second it’s put into an investment account – and over time it’ll only grow faster and faster. So if you’re aiming to achieve a certain financial goal, compound interest can help you get there quicker.
3. Compound interest can help you overcome inflation.
Every year, the cost of goods and services typically rises by a few percentage points. This phenomenon is known as inflation. In order to maintain your purchasing power, you need your savings to grow at least as fast as inflation. Compound interest lets you do this, giving you a significant advantage over the long run.
Before we proceed…
If you’re earning compound interest, it becomes crucial to understand how much tax you’ll owe on that income. This is because different types of wealth are taxed at different rates.
You can easily determine how much tax is due on your investment income by using a tax calculator, reading about common tax myths, or generating your 1099 form online.
Where can I put my money to earn compound interest?
1. High-yield savings account. This type of account offers the best return on your investment, and it’s also very safe. You can typically find these accounts at online banks or credit unions.
2. Certificate of deposit. This type of savings account offers a higher interest rate than a regular savings account. However, you can’t withdraw money from a CD until the end of the term, which is anywhere from six months to five years.
3. Money market account. This savings account typically offers a higher interest rate in return for depositing a larger minimum balance. Money market accounts also offer limited check-writing privileges and the ability to use a debit card.
4. Checking account. The interest rate on a checking account is usually lower than the interest rate on a savings account or certificate of deposit (CD). However, many banks offer bonuses for signing up for a checking account, and some offer no-fee checking accounts.
5. Treasury bills. T-bills are short-term government bonds that usually mature in three, six, or twelve months. They are backed by the full faith and credit of the United States government, so they are very safe investments.
6. Short-term bonds. These are bonds that will mature in one to three years. The longer the maturity date, the higher the interest rate.
7. Riskier options. You can also consider investing in stocks or stock mutual funds, buying bonds or bond mutual funds, and starting a small business. However, these are all relatively high-risk investments, so be sure to do your research before investing any money.
Compound Interest vs Simple Interest
Simple interest is a form of investment in which you only earn interest on your original investment. This means that even if you left $10,000 in an 8% simple interest account for 20 years, you would only ever accumulate $13,200 – a whopping difference compared to our prior example.
Meanwhile, compound interest is a powerful tool that can help your money grow faster than if it were invested with simple interest. This occurs because you not only earn interest on your original investment but also on the accumulated interest. As a result, compound interest is an excellent way to build your savings over time.
It’s hard to overstate the power of compound interest. In the long run, it can turn even small sums of money into fortunes. If you’re not taking advantage of compound interest, start today! Review your budget, savings plan, and get started on the road to financial security.