Are You Taking Advantage of Compounding Interest?
Decades after his death, people have been trying to attribute a quote about compound interest to Albert Einstein. While the quote varies, and attribution is problematic, the sentiment holds true: “Compound interest is the most powerful force in the universe.”
Another popular quote, with an unknown origin (but sometimes attributed to Einstein) is this: “Those who understand interest earn it; those who don’t, pay it.” A great quote. If you understand compound interest, then you can use it to your advantage, building your assets.
What is Compound Interest?
Basically, compound interest is earning interest on your interest. If you are earning simple interest, you only receive interest based on your principal. However, if you are earning compound interest, the interest earnings you receive periodically are added to your principal – and you earn interest on the whole.
If you earn simple interest at a 4% rate on $100, you will get $4 in earnings at the end of the year. However, if you earn interest that is compound every quarter, the story changes. First, you have to divide that 4% by 4 in order to see how much you get each quarter. In this case, you end up with 1% interest compounded each period.
At the end of the first quarter, your $100 has earned 1%, or $1. That $1 is added to your $100 to get $101. At the close of the second quarter, 1% is earned on the $101 is $1.01. So, now you have $102.01. At the end of the third quarter, your interest amounts to $1.02. Now you have $103.03 earning interest. At the end of the fourth quarter, your new total is $104.05. Of course, working with small numbers, the difference of $0.05 isn’t very significant. But if you are dealing with larger numbers, it starts to matter.
Let’s say you have $10,000. You put it in an account for 20 years at 7% annual interest. Using a comparison calculator from Money Chimp, you see that with simple interest, your total future value is $24,000. If the interest is compounded just once a year, though, the future value would be $38,696.84. Compound it four times a year, and you end up with $40,063.92. And that’s without adding anything to your original $10,000. If you use the compound interest calculator to show that you add $2,000 a year, you end up with $127,464.03.
Earning Compound Interest
If you want to earn compound interest, there are plenty of ways to do it. Investing is one of the best ways to earn compound interest. You can use the following investment vehicles to build wealth with the help of compound interest:
- Stocks (including dividend stocks)
- Mutual funds
- Retirement accounts (401k, IRA, etc.)
Depending on the type of investments you choose, though, there are varying degrees of risk. Make sure that you carefully choose investments that will help you meet your goals, while paying attention to your risk tolerance. You can run different scenarios using different compound interest calculators like the one at EconEdLink or retirement calculators found at various web sites.
Finally, imagine what you could do if you created a supplemental income stream and then invested that money. Putting your income to work for you, earning compound interest, is a great way to build wealth.