The Magic of Compound Interest

With a compounding interest structure, your money works diligently for you in an investment
, continually feeding upon itself to grow at a substantially faster rate than with simple interest. An account that offers compound interest first pays you interest on your principal, and then, when it’s time to pay interest again, the account pays interest on your principal and the previous interest that you earned. In other words, the interest that you’re paid adds to and becomes part of the principal that accrues interest during the next period. You have a continuously growing principal amount without having to make another deposit. Yet if you do choose to make regular deposits to go along with your automatically growing principal, over time, you can enjoy impressive results.

The savvy investor, when given a choice between a good investment with compound interest and a great investment with simple interest, will pick the good investment every time. Such an investor knows that, over time, the investment that compounds will outperform the other.

To understand this better, imagine you have three friends, Charlie, Kim and Sally, each with money to invest. Charlie has $30,000. Kim and Sally each have $10,000 to invest. For the sake of the example, imagine that Charlie places his money into a 30-year investment that pays 12 percent simple interest annually (note that this sort of investment would actually be highly unusual). Kim and Sally also put their money into 30-year investment vehicles at 12 percent annual interest. However, theirs accrue compound interest, with Kim’s compounding yearly and Sally’s investment compounding quarterly.

After 30 years, here’s what their accounts would look like:

* The total value of Charlie’s investment would be $138,000 (principal and interest).
* The total value of Kim’s investment would be $299,599.22.
* The total value of Sally’s account would be $347,109.87.
* Moreover, if Sally made $50 additional deposits every two weeks during the 30-year period, her balance would increase to $755,859.58.

As you can readily see, even though Charlie had three times as much money to invest initially, the compounding investments of Kim and Sally greatly outperformed his investment in the long run. Now let’s hit a little closer to home.

Most of us don’t have a large sum to sink into an investment for 30 years. What would it be like if Sally had only $100 to invest, but she could continue to deposit an additional $100 into the account every month over the full 30 years? At a more real-worldly compounded rate of 8 percent, let’s see how she’d fare:

* After 30 years, Sally’s account would be worth $150,129.52, which still outperforms Charlie’s investment.
* If she deposited $25 weekly instead of $100 monthly (only $50 more per year), her balance after 30 years would be $165,034.94.

You get the picture. The point is that compounding interest works, and works well. If you’re not using it to maximize your money, then get to it. You don’t have to start with much. You simply have to be consistent—but you must start. Every day that you don’t have this powerful principle in your financial arsenal is money that you’re losing in the long run. Use the compound-interest calculator to play with the numbers yourself. It’s just like magic; so what are you waiting for?

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