As you dive deeper into personal finance, you’ll find many claims surrounding the power of compound interest. This can leave you to wonder, "how does compound interest work?" and how it can impact your life. Well, this concept can have significant consequences for your financial future. With that being said, let’s take a closer look at how compound interest works.
What is compound interest?
Compound interest is the interest that you earn on previously earned interest. It can cause an initial investment or debt to grow over time without additional intervention. If you make a sound investment, compound interest can help it grow dramatically over time.
If your debt is subject to compounding interest, the balance owed can quickly spiral out of control. Depending on the situation, compound interest can help you to build wealth over the long term or cause financial hardship.
How does compound interest work?
Let’s break down the process of how an investment can compound to better understand how compound interest works.
The process of compound interest starts when an initial investment earns interest. At that point, the interest is added to the initial investment capital. When the investment earns interest again, it will determine the newly earned interest based on both the original investment and the earned interest.
As the process continues, the size of the investment will grow. Each time the investment earns interest, it will be added to the total investment amount. The loop will continue to allow the investment to grow substantially without additional investment capital. With time, this cycle can lead to the dramatic growth of the original investment.
What factors determine your compound interest returns?
The compounding power can make a difference in your investment portfolio. Here are the two factors that can impact your compound interest returns.
The time you allow your investments to compound will have a big impact on the end result. The more time you can enable your investment to grow, the more growth you will see. Even relatively small investments made early in life can have the ability to compound into life-changing sums of money. With that, I cannot understate the power of compounding.
2. The interest rate earned on an investment
In addition to the time you allow your investment to grow, the interest rate you earn will impact the results. Of course, a higher interest rate will produce a higher ending balance when compounding is taken into account.
However, you should be wary of seeking out the highest interest rate at all costs. Higher interest rates are associated with higher risk investments. Consider your risk tolerance and investment strategy before seeking out the highest possible interest rates to maximize your compounding opportunities.
Examples of compound interest
Here are two examples of compound interest, as it relates to leveraging it or not. You'll see how compounding can help you boost your savings and investments if you take advantage of it!
Let’s say that at 25 years old, you start to invest $5,000 each year for the next 40 years. Over the 40 years, you’ve experienced an average investment return of 6%. After 40 years and with the help of compounding, your investment would be worth $773.816.
Let’s take a look at a different wealth-building strategy - saving instead of investing. At 25 years old, you set aside $5,000 in a savings account and continue to add $5,000 to this account for the next 40 years. If your account has the current average savings account interest rate of 0.09%, then your savings would be worth $203,552 after 40 years.
Clearly, there is a major difference in the results thanks to different interest rates. As you decide how to balance investment priorities and savings goals, keep this in mind.
Curious about how compound interest could affect your specific strategy, then check out this free calculator. You can play around with different scenarios to better understand how this could impact your own life.
How the power of compound interest can work for you
As we mentioned, the two most important factors for compound interest are time and interest rates. The most effective way to boost your compound interest returns is to start investing as soon as possible. With more time on your side, you stand to gain more from compound interest. Make a plan to save early and save often.
Although high-interest investments may seem to promise higher long-term rewards, it is a better idea to seek out investments with less risk. Don’t seek out high-risk investments with high risks. A risky investment is more likely to tank at some point in your long investment career which will negatively impact your long-term returns. Instead, seek out moderate investment returns with less risk and rely on compounding to boost your long term returns.
As you map out an investment strategy, make sure to keep your strategy focused on long term gains. Many of us are easily tempted by high-risk investments that offer big rewards. After all, who doesn’t want an outstanding investment return? But giving in to this temptation for short term gain could derail your long term returns.
How the power of compound interest can work against you
Although compound interest can provide a dramatic boost to your investment strategy, there is a dark side that you need to be aware of. Compounding interest can allow investments to grow. But the same power can allow debt to build with a relentless growth pattern.
Unfortunately, the power of compounding is how many find it difficult to pay off credit card debt and other high-interest debt. If you find yourself facing this challenge, the best plan of attack is to use the debt snowball strategy to eliminate debt for good.
The bottom line
If you are able to harness it to your advantage, compounding interest can be a powerful force. It will require a solid investment strategy and a commitment to saving. But a carefully laid out investment plan could transform your financial future.
Don’t wait to move towards your financial goals. Consider taking a free course offered by Clever Girl Finance that will walk you through the steps of building an investment plan and give practical advice on managing your investments effectively.