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Compound Interest -Why It Matters

compound interest

The most efficient way to gain wealth gradually

Once dubbed by Albert Einstein as the 8th wonder of the world, compound interest is undoubtedly the most powerful tool that can get you to financial wealth. However, very few people know of its benefits, or they don’t believe in it enough to make the necessary effort and make it part of their financial plans.

In this article, I will go through the benefits associated with Compound Interest and provide you with some tips to help you start implementing it.

What is compounding?

Compound interest is when you begin earning interest on the interest you receive – this makes it possible for your money to multiply at an accelerated rate.

Let’s say you managed to save $1,000 this year, and invest the sum in a fund which earns you approximately 10% interest per year. You will have $1,100 after one year. If the fund earns another 10% the next year on that $1,100, you end up with $1,210 by the end of year two. The process continues, until eventually the original lump sum, i.e. the $1,000 will be eclipsed by the amount of interest you gained.

Getting the most out of compounding

Your money can compound more effectively when you give it more time to compound. That is why many financial professionals advise that the earlier you start saving and investing, the better as your money will have more time to grow, and even weather any financial downturns, recessions and a period of inflation, which may all erode the returns that you hope to achieve over time.

There are several compound interest calculators available for free on the internet that can help you calculate how much your money can grow over a period of time. In the following example, you will see why patience is the ultimate ingredient to building your wealth nest when it comes to compounding:

Jack is 30 years old, and he wishes to save $1 million by the age of 65 (the year he plans to retire). He can afford to save $500 per month to achieve this target, but has already calculated that if he saves this amount regularly and puts it in a normal account in the bank, he would have $210,000 by his 65th year.  Quite way off his $1 million target.

But what if Jack decides to invest the $500 instead? What if he starts putting it in a balanced investment portfolio and lets it grow there over time, giving his money time and space, and letting it flourish?

With a 10% annual return, Jack would have his $1 million by the age of 60 (5 years before his target retirement age).

Scratching your head at the 10% annual return, considering the current financial turmoil and inflation? Although the past is not a guarantee for future returns, it would be remiss not to consider that the S&P 500 (an index tracking the performance of the 500 largest companies listed on stock exchanges) returned an average of 10% a year for the past 100 years.

Baulking at the $500 regular monthly savings? I get it, it is not always easy to save such a sum regularly. Let’s take it a notch lower and go with $300 a month instead. You will still end up with approximately $600,000 by age 60, or even the sum Jack wanted, a whopping $1 million if you’re willing to wait another 5 years (i.e. till the age of 65) to cash in your money.

Time is the magic

What gives compound interest its superpower? Time! Patience is key if you want to reap the rewards of this financial tool – quitting early won’t get you far. With a bit of self-control, your hard-earned money will work wonders with just enough time and effort on your part. Now that’s something worth waiting for!