Compound interest has a truly magical power that defies conventional expectations. If you save and invest consistently over a long period of time, a small amount of money can turn into a substantial fortune. The results of compound interest may seem almost unbelievable.
Consumer Financial Protection Bureau (CFPB) compound interest is defined very simply. “When you earn interest on both the money you save and the interest you earn.”
Yes, compound interest is a concept in finance that involves earning interest or earnings not only on the money you have initially, but also on the interest that accumulates over time. But these explanations don’t really capture the magic of compound interest. Reinvesting the interest or profits you earn from your money allows for exponential growth as interest continues to compound. Exponential growth is magic.
Exponential growth is a growth pattern in which there is an accelerating increase in volume or value over time, resulting in significant overall expansion.
Simply put, compound interest is like a snowball rolling in wet snow, getting bigger and bigger. Your money grows not only by the initial investment, but also by the interest accrued on that investment.
So let’s say you invested $1,000 this year and got a 6% return. If nothing else, next year he will be $1,060. And without doing anything else, the next year he will earn $63.60. However, $3.60 added to the initial extra $60 doesn’t seem like much. I didn’t have to do anything to make that money. And that magic money continues to grow over time, and it does.
The longer you keep your money invested and the interest compounded, the more pronounced the growth will be. Compound interest has the power to grow your savings and investments over time, making it a valuable tool for building wealth and achieving financial goals.
The longer the period, the more magical the compounding effect, and even a modest contribution can produce amazing results. Compounding interest weaves its allure, enabling the realization of financial goals beyond imagining, proving that small, sustained actions can open the door to extraordinary wealth and prosperity.
What’s the secret to keeping your money invested for the long term? Start saving and investing as soon as possible!
An example of how the sooner you start saving, investing, and compounding, the better
Here is an example showing why it is beneficial to start compounding early.
Consider two individuals, Ben and Chris. Assuming they both retire at her 65, the savings would be:
- Ben starts saving at age 25 and contributes $1,250 every month for 40 years (480 months).
- Total donation over 40 years: $600,000 ($1,250 x 480).
- Assuming an average annual rate of return of 7%, the total amount of retirement accounts at age 65 will be approximately $4,365,018.
- Chris started saving at age 45. Suppose her salary is twice that of Ben’s and that of $150,000 she can contribute 20% or $2,500 per month she can for 20 years (240 months).
- This equates to twice as much monthly savings as Ben saved in six months.
- Total donation over 20 years: $600,000 ($2,500 x 240).
- This is the same one that Ben saved.
- Assuming an average annual rate of return of 6%, the total retirement benefits at age 65 will be approximately $1,142,362.
- This amount is probably enough to live on after retirement, $3 million less than what Ben has at 65.
Ben and Chris both contributed the same amount of money to their savings, but Ben, who started saving 20 years ago, ended up Significant increase in retirement savings balance Despite Chris’ high monthly donation (over $3 million). This highlights the importance of starting early and giving yourself more time to grow your investment.
Note: The examples above show the value of starting early, but even if you don’t start saving until you’re in your 30s or 40s, consistently large contributions can lead to large retirement savings by retirement age. It is important to note that the
Chris ended up making over $1 million!
In the example above, we can see that both Ben and Chris are consistently saving and investing. This solid commitment to savings isn’t magical like compound interest, but it’s the key to long-term wealth creation.
Imagine compound interest as a magical seed that grows into an amazing tree when planted in fertile soil.
First, the seed represents the initial investment or savings. Over time, this seed will sprout and begin to bear fruit of interest. However, rather than picking these berries, carefully collect them and replant them at the base of the tree.
With each passing season, these fruits grow on new trees, each bearing its own fruit in abundance. When this cycle is repeated, the forest of trees expands exponentially, resulting in a bountiful harvest. Compound interest works similarly, with the interest earned seeding new investments to grow, creating a thriving forest of wealth. Just like a small seed can turn into a majestic forest, compound interest has the magical power to turn a small investment into a big financial success over time.
Being able to think in the context of your own financial situation may help you understand the somewhat abstract concept of compound interest.
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