Compound interest

What does Warren Buffett know that you ignore about compound interest?

What does Warren Buffett know that you ignore about compound interest?

“The most powerful force in the universe.”

“The greatest invention in the history of mankind.”

Many people claim that Albert Einstein used these expressions to describe compound interest.

Whether he did or not, one thing is true: When considering a wealth building strategy, compound interest is a very powerful savings tool. And that’s pretty cool. Read on to learn all about the composition and the best way to reap the rewards.

What is compound interest?

stacked coins showing a graph of over-proportional growth due to compound interest

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Watch your money grow with compound interest.

Compound interest builds your money at an accelerated rate. It’s interest on top of interest: your deposits earn interest, and interest also earns interest.

It can mean incredible growth over time.

Suppose you deposit $ 20,000 into a high yield savings account paying 3.25% compound interest annually.

  • In the first year, you would earn $ 650 in interest and you would have a total of $ 20,650.

  • In the second year, you would earn $ 671 in interest, on principal and past interest, and you would have a total of $ 21,321.

  • In the third year, you would earn $ 693 in interest, on principal and past interest, and you would have a total of $ 22,014.

  • In the fourth year, you would earn $ 715 in interest, on principal and past interest, and you would have a total of $ 22,730.

  • In the fifth year, you would earn $ 739 in interest, on principal and past interest, and you would have a total of $ 23,468.

Compound interest is different from simple interest, which is only earned on the initial principal from year to year.

Here’s what that $ 20,000 investment would look like with simple interest paid over the same period:

  • In the first year, you would earn $ 650 in interest and you would have a total of $ 20,650.

  • In the second year, you will earn an additional $ 650 in interest, on principal only, and you will have a total of $ 21,300.

  • In the third year, you will earn an additional $ 650 in interest, on principal only, and you will have a total of $ 21,950.

  • In the fourth year, you will earn an additional $ 650 in interest, on principal only, and you will have a total of $ 22,600.

  • In the fifth year, you will earn an additional $ 650 in interest, on principal only, and you will have a total of $ 23,250.

The difference between $ 23,468 with compound interest and $ 23,250 with simple interest may seem small. But the comparison is much more impressive in the longer term.

After 23 years with compound interest, you will double more than your initial investment for $ 41,735, while with simple interest, you will only watch $ 34,950.

And, after 50 years, compound interest will turn your $ 20,000 into nearly $ 100,000 ($ 98,977, to be precise), versus $ 52,500 with simple interest.

Just imagine the power of compound interest if you regularly contribute to that savings account.

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Compound interest accounts

growing piles of money with investment graph arrow implying growth.

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Choose the right savings account to help you grow.

Here’s the good news: you’ll find that compound interest is far more common than mere interest when looking for a place to store your savings. There are several types of savings vehicles you can open to make compound interest work for you.

Certificates of deposit (CD) are probably one of the safest places to keep your money and watch it grow. CDs usually offer the highest interest rates, but they lock in your funds for a fixed period of time.

These terms vary from six months to five years or more, and there are penalties for early withdrawal. When the term ends, you have the option of renewing and growing your money in the CD, or withdrawing it.

The locked nature of CDs can be restrictive, meaning you shouldn’t use a CD as an emergency savings account because you won’t have quick access to money if something happens. (And something always come !)

You also cannot deposit more funds on a CD until it has expired and renewed.

High yield savings accounts will give you the flexibility to withdraw and deposit funds whenever you want, and – although the interest rates aren’t as high as the rates on CDs – the accounts offer solid returns over time.

To keep your savings more nimble, a high yield savings account might work better.

Note that these accounts generally require a minimum deposit. When shopping for a high yield savings account, compare the terms and choose the account that works best for you.

Be like Buffett

Warren Buffett smiling and gesturing with both hands

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Please, please make me like Warren Buffett.

When talking about successful investing, removing the Oracle of Omaha name is inevitable. Warren Buffett is a shining example of how you can make your money grow through funding.

“My wealth came from a combination of living in America, some lucky genes and compound interests,” he once wrote.

If you look at examples of Buffett’s portfolios, you’ll notice that he’s mostly invested in stocks that pay off. dividends – which offer another form of composition.

One of the best things you can do, if you’re ok with a little bit of risk, is to invest in a mix of stocks, mutual funds, and ETFs that pay dividends. Make sure you do your research.

When dividends are reinvested, they generate more dividends, and the compound dance continues.

If investing on your own intimidates you, automated investing services, such as Wealthsimple and Blooom, do the heavy lifting for you and lower the cost of investment fees.

Whether you’re saving for the short term or investing for the long term, compound interest is your best friend. So give it a hug and let it work for you.

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