What Compound Interest Really Means and How to Use It to Your Advantage

What is compound interest?

Compound interest is a type of interest applied to savings and investments; it’s applied to the principal as well as to earnings. That is compound interest is calculated not only on the initial amount deposited but also on the earnings generated by that amount.

For example, say you invest $10,000 at a 5% interest rate. If interest is compounded annually, at the end of the year, you’ll have $10,500 in your account (not including additional investments you may make during the year). If interest is compounded monthly, you’ll have $10,505 at the end of the year.

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Why is compound interest so important?

If you earn compound interest from an investment instead of simple interest from a loan, you could end up with more money over time.

This is because compound interest allows you to earn interest on your interest. As an example, let’s say you have $100,000 in the bank and decide to add $500 per month to the account, which will earn 5% interest.

That investment will generate $6,000 in interest after 5 years. If you withdraw the $100,000 and take out the initial $6,000 that you put in, you’ll get $94,000 after 5 years.

If you leave the $100,000 in the account and continue adding $500 per month, you’ll generate $68,000 in interest over the same 5-year period.

That’s because you’ll earn interest on the $6,000 in interest you earned (and the interest on that interest, and so forth). You’ll have $136,000 after 5 years, which is $34,000 more than if you had taken out the initial investment.

How can you benefit from compound interest?

One of the best ways to benefit from compound interest is to start investing as soon as possible. The sooner you start saving and/or investing, the more years you have to allow compound interest to work in your favor.

If you start investing early enough, you may be able to fund your retirement without having to depend on a pension or Social Security. Another way to benefit from compound interest is to select investments that have the potential to generate a high rate of return. You can look for investments that offer interest rates that are higher than the rate of inflation.

As the rate of inflation rises, the value of the dollar falls. So, to get the same purchasing power that you would have had with a lower-interest investment, you’d have to put more money into the higher-interest investment.

How to invest using compound interest

To truly maximize the power of compound interest, you should try to find investments with high-interest rates. Many online savings accounts offer interest rates that are significantly higher than what traditional banks offer.

You can also consider investing in stocks and bonds, which may not offer a high rate of return but have the potential to grow your money over time. You may also want to consider taking out a loan to invest in a high-yield investment, assuming the interest on the loan is lower than the interest on the investment.

This way, you’ll be able to invest more money than you could with just the money in your bank account.

Summing up

Compound interest happens when interest is added to the principal, rather than just being applied to the initial amount deposited.

That means if you invest $10,000 at 5% interest, you won’t have $10,500 after a year; you’ll have $10,505. You can maximize the power of compound interest by starting to invest as early as possible, selecting investments that have the potential to generate a high rate of return, and finding ways to invest more money.

When you start investing, it’s important to understand that the money you put into your investment won’t be available to you immediately. You’ll have to be patient and wait for the investment to grow.