Compound Interest is an important concept to understand in helping you build your wealth. Understanding compound interest will help you understand why it is important to get the best interest and yield on your accounts. It’s not magic it’s math, and it helps you grow your wealth.
Compound interest is what can make your deposits grow faster, similar to the “snowball effect.” When you roll a snowball down the hill, the snowball continues to grow upon itself and ends up growing so big it becomes a giant avalanche. Compound interest works relatively the same way, earning money on your initial deposit and on the interest that you earned, as well. This cycle of compounding your investment and the interest that you earn leads to significant increases in the balance over time. The compounding of interest can happen in several manners depending on the compounding period, which can be measured daily, monthly, quarterly, or annually. In most cases interest is calculated on a monthly basis. This is typically the case with savings accounts and certificates of deposits (CDs). When shopping rates, look at the annual percentage yield (A.P.Y.), it is the true rate that takes the compounding into account on an annual basis.
In the example below, the initial deposit is $10,000 with an annual compound interest rate of 5%. The money is left in an investment account for fifty years. After the first year you have made $500 in interest and have a total amount of $10,500. That $10,500 is earning interest the entire second year and now you made $525 in interest with a total balance of $11,025. This happens year after year, and at the end of the fifty years you have $114,674 without ever adding to the principle investment. That is the magic of compound interest.
|Compound Interest Annually||Total|
|Year 1||$10,000 x 5% = $500||$10,500.00|
|Year 2||$10,500 x 5%= $525||$11,025.00|
|Year 3||$11,025 x 5% = $551.25||$11,576.25|
|Year 4||$11,576.25 x 5% = $578.81||$12,155.06|
|Year 5||$12,155.06 x 5% = $607.75||$12,762.81|
|Year 10||$15,513.25 x 5% = $775.66||$16,288.91|
|Year 25||$32,251.00 x 5% = $1,612.55||$33,863.55|
|Year 50||$109,213.33 x5% = $5,460.67||$114,674.00|
Compound interest works in your favor, especially when you are able to deposit funds and leave them to grow. Combining compound interest with periodic deposits to your account, perhaps on regular intervals, helps you build savings for your future even faster.
Let’s take a look at the magic of compound interest while continuing to contribute to the principle of the investment. We can deposit the same $10,000, in the same investment account earning a 5% yield and compounding monthly. With this example, we add an additional $250 each month to the account. Compounding monthly we will need to divide the interest rate by twelve for the amount being paid on a monthly basis. Because we are earning a 5% yield on an annual basis, we will be earning 0.41667% on a monthly basis. After the first month we would earn $41.67 in interest and deposit an additional $250, bringing the total balance to $10,291.67. Doing this for next five years would result in having an account worth $29,832.11. After fifty years, the account balance would be $788,357.98 with a total contribution of only $160,000 ($10,000 initially and $150,000 in monthly deposits) over the fifty-year period.
|Saving $250 Per Month With Compound Interest Monthly||Total|
|Month 1||$10,000 x (5%/12) = $41.67 + $250||$10,291.67|
|Month 2||$10,291.67 x (5%/12) = $42.88 + $250||$10,584.55|
|Month 3||$10,584.55 x (5%/12) = $44.10 +$250||$10,878.65|
|Month 12 Year 1||$13,276.02 x (5%/12) = $55.32 + $250||$13,581.33|
|Month 24 Year 2||$17,024.96 x (5%/12) = $70.94 + $250||$17,345.89|
|Month 36 Year 3||$20,965.70 x (5%/12) = $87.36 + $250||$21,303.06|
|Month 60 Year 5||$29,462.35 x (5%/12) = $122.76 + $250||$29,835.11|
|Month 120 Year 10||$54,812.29 x (5%/12) = $228.38 + $250||$55,290.68|
|Month 300 Year 25||$182,679.29 x (5%/12) = $761.16 + $250||$183,690.46|
|Month 600 Year 50||$784,837.82 x (5%/12) = $3,270.16 + $250||$788,357.98|
No matter how you choose to save for your future, the most important thing that you can do now is to open an account and start contributing to it on a regular basis, whether you’re starting a savings account, retirement account, or a standard investment account, this will allow you to take full advantage of compounding interest rates. The sooner you begin investing, the larger you balances will be when you reach retirement age. Compound interest rates will work in your favor over the long run.
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