The power of compound interest

When it comes to investing, time is your most valuable asset and compound interest is your best friend. If you’ve just landed your first job or are jumping into a side business, but you’re not sure what “compound interest” means in the last sentence, you’ve come to the right place.

As a young person, you are in a great position to have your money start working for you. Why? Growth accelerates over time and you have plenty of time ahead, which means saving early pays off big in the future. Here’s everything you need to know about compound interest and how you can profit from it.

What is compound interest?

To understand compound interest, you must first know simple interest. Simple interest is the interest earned on your savings only. Let’s say you have $ 100 that you want to invest. This is called your principal balance. You go to the bank and deposit it into a savings account at an interest rate of 1%. This means that once your principal balance of $ 100 has been saved for a period (usually defined as a year), you will accumulate 1% on your investment, or $ 1. This repeats every year, which means the next year you get another 1%, or $ 1, and so on. It’s a simple interest.

Compound interest, however, is the interest you earn on both your principal balance AND the interest you earn over time, which makes your wealth grow faster over the course of your life. Do you remember learning the exhibitors at school? Compound interest is a similar concept.

Let’s go back to that initial $ 100. Suppose you deposited that same amount in the bank at a compound interest rate of 1% per annum. How does it increase differently from a simple interest rate? Well, after the first year it’s not. Your principal balance will always have brought you the same amount: $ 1. But the following year, you’ll earn 1% interest on your new account balance of $ 101, instead of your initial deposit, that main balance of $ 100. Instead of earning $ 1 on the sum, you earn $ 1.01, bringing your new account balance to $ 102.01. The following year, that $ 102.01 accumulates 1% interest, becoming $ 103.03. It continues to build up or multiply on its own, increasing the amount you earn the following year, the year after, and so on.

How does compound interest work?

Since compound interest includes all previously accrued interest, it grows at an ever faster rate. That’s why the number of funding periods, or years you’ve saved, makes a significant difference and why you want to start investing as early as possible.

When you put money in a compound interest account and leave it out, your money will grow. In the previous example, you set aside only $ 100 once and let the compound interest do the work. However, if you were to add more money to your main account balance on an ongoing basis, for example, quarterly, monthly, or even every paycheck, your money can really start to work for you.

Of course, it’s hard to imagine putting money aside consistently when you’re young and starting over with your finances. The benefit of doing so, however, is very real. Investing a little each month, even just $ 100, from an early age has the potential to become a substantial amount of money you can count on when the time comes to retire.

What does compound interest look like in practice?

Compound interest in real life looks different depending on where you invest your money, how much you set aside, and your rate of return.

Consider the following scenario.

Investor 1, Charlie, started saving at age 25. He set aside $ 1,000 a month for 10 years until he was 35. 65 years.

Investor 2, Molly, started saving at age 35. She also set aside $ 1,000 per month for 10 years until she was 45. Like Charlie, she left her investment account balance, where it continued to accumulate at a rate of 1.5% until she reached age. 65.

Investor three, Max, didn’t start investing until he was 45. He too invested $ 1,000 a month for 10 years, stopping his savings at age 55, then allowed his money to accumulate at a rate of 1.5% until his 65th birthday.

All three investors contributed the same amount, $ 120,000, to their savings over a 10-year period. Yet because of when they started saving, their end results in retirement were dramatically different. Charlie ended up with a balance of $ 203,105 in savings, while Molly had $ 174,831 and Max only had $ 150,492.