Compound interest is something that every investor needs to know which most people do know. For those who don’t understand what compound interest is, it is when you make an initial investment where interest is applied. It also includes accumulated interest from previous periods. Basically, it is earning interest on top of your initial interest.
Compound interest is very effective and can help build your wealth to help achieve long-term financial goals. Furthermore, it helps grow your wealth much quicker than just basic interest. The more compound periods there are, the more compound interest is generated over time. It helps accelerate your wealth over a long period. However, if you have bad debt, compound interest can make it more difficult to pay off your debts.
So, How Does Compound Interest Is Important?
Compound interest is calculated by multiplying your initial investment by one plus the annual interest rate raised to the number of compound periods minus one. For those mathematicians, the formula can be seen below:
P = C (1 + r/n)nt
C = initial deposit
r = interest rate
n = how often the interest is paid
t = how many years the money has been invested
P = is the final value of your investment/savings
Now, if you want to calculate how to achieve a certain number. For example, if you wanted to achieve $10,000. You would calculate this by getting your initial investment, let’s say $2000, and it had a 5% interest rate, which would take roughly 14.4 years. This is also known as the rule of 72.
Why Starting Early Is Important
You may have heard other investors say that starting early is important but not many elaborate on the reason why. You have a higher chance of a stock value increasing however, the main reason why you should start investing earlier is because of compound interest. Let’s take a look at how this would work. If you deposited $10,000 and waited ten years and received a 5% annual interest, this would earn you an extra $500 per year and a total of $5,000 at the end of the ten years.
Now, we understand that it is difficult to pull out $10,000 from your back pocket and invest it; however, gradually building your savings/investment account will benefit you hugely and will help to generate more wealth for your future. Eventually, you would build a large investment portfolio in the future which will help to an early retirement. Gradual growth is much better than investing in lump sums as your investment portfolio will be less volatile in comparison to investing when you think a stock is on the lower side, attempting to catch it at a low price.
Compounding Interest Periods
Compound interest periods are something that you will need to learn. This is the period when the interest is added to the investment account. Interest can be compounded very often and it may occur daily but only credited monthly. Once the interest is credited/added to the current balance of the savings account it will earn additional interest on top of the original interest.
The standard compound frequency schedule will occur to some accounts which include; Savings accounts, certificates of deposit, series I bond, loans, and credit cards.
Compounding Period Frequency
More common compounding of interest is far more beneficial for the investor/creditor however this is not the case with the borrower. The more compounding periods, the higher value of the investment will increase over a longer period.
Why You Start Early
Saving when you are younger doesn’t cross your mind. The same goes for investing. One of the reasons for this is that we are not taught the facts of compound interest. We are only taught about saving to create an “emergency fund” which is great but to build a significant amount of wealth, the best method for this would be to invest early. The earlier you start, the earlier you can retire but as a young person, it is difficult to think like this when you are in education. As we have previously discussed, the more compound interest periods occur, the more money you have which is why you should start early.
The Positives and Negatives of Compound Interest
Now, let’s summarise the positives and negatives of compound interest. Starting with the positives first.
- Helps to build long-term wealth
- Reduces the severity of wealth erosion risk
- Compounding can work for you when making loan repayments
There are a few negatives with compound interest as well such as.
- Doesn’t work in the consumer’s favour when making minimum payments on a credit card and high-interest loans.
- Like everything, your returns are taxed
- Can be difficult to calculate/predict as interest rates can vary each year.
When you have built up the date, you need to pay it off as soon as you can due to high interest rates and compound interest. If the debt does get out of hand then you should seek debt help to pay off those debts.
How Does Compound Interest Work With Investing?
Those who are involved with the investing world would have likely heard of Warren Buffet, arguably the most successful investor and he is one person who has spoken a lot about how he has generated his wealth and compound interest is often mentioned. Warren Buffet has accumulated 99% of his wealth after he turned 65.
Warren Buffet is a massive advocate for compound interest when investing so you should be too. Opening a brokerage account like a DRIP (dividend reinvestment plan) is allowing you to use the power of compounding for your investments.
There are hundreds of stocks that offer dividend payments and these stocks allow you to take advantage of compound interest. For example, some dividend stocks such as International Seaways pay a dividend yield of 11.10% which is one of the highest in the industry.
Summary
No matter how much it is, compound interest will benefit your investment portfolio so the earlier you start the better. Warren Buffett started at the age of 11 and although it wasn’t a large amount of money, he immediately invested his money straight away. It may have been one of the best things he learned at such a young age and it helped him build the right habits where he is now one of the richest people in the world.
Before investing you should consider paying off your debts first before investing. Debt interest can be much more than compound interest so it is important you pay off your debts first. If paying your debts is difficult then get debt help to pay off your debts.