“Compound interest is the eighth wonder of the world, he who understands it – earns it. He who doesn’t – pays it”
Albert Einstein
Compounding interest is what allows you to become wealthier, and its power is accessible to everyone. In this article, we will discuss important facts about compound interest, and ways you can take advantage of it.
Facts about Compound Interest
Definition.
According to Wikipedia Compound interest is – “the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest” (Credit: Wikipedia). Let’s unpack this definition.
How compound interest works
When you invest, your money will grow by a consistent percentage, on average, every year, if invested wisely. The way your money grows, its growth is based on the existing value. Depending on how long that money is invested, some of the current value is the form of your contributions, and the rest is the return you have made from your investment. The more time it is invested, the more it will be able to grow from the previous growth. With compounding interest, time is the second most ingredient and the stronger factor over many years.
Rule of 72
“The Rule of 72 is a simple way to determine how long an investment will take to double given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors obtain a rough estimate of how many years it will take for the initial investment to duplicate itself”. (Credit: Investopedia)
Scenario Example:
If your money is consistently earning compound interest, it is easy to calculate how quickly your money will double.
Let’s say you invested $5,000, and you’ve selected good investments (more to come in the article), which consistently average 10% compound annual return.
We can take this value, and put it into our formula, 72/ (10% return) = 7,2 years. Your money will double every seventh year. So in 2026, your $5,000 will be worth $10,000. In 2033, that money will be worth $20,000. In 2040, your original $5,000 will be worth $40,000.
This is the power of compound interest, and you see once you have your money, you will gain more from the work the money does than the work you do.
How Investing Process Works
Invest in the stock market.
The easiest and the most effective, way to begin your journey is by investing in the stock market.
The stock market has been the most effective way for middle-class Americans to become millionaires over the course of their lives with modest incomes. The stock market allows you to purchase shares of stock in a company. Stocks merely is owning a small part of a company.
How do you make money in the stock market?
There are two primary ways to make money: the growth in value and dividends. As the company grows and earns more money, the stock becomes more valuable, and you receive a return on your investment. Further, some stocks pay dividends. Dividends are payments made to shareholders regularly to incentivize them to keep the stock.
Buy Mutual Funds.
Another important term to know is Mutual Fund. A mutual fund is an investment made up of a pool of money collected from other investors, used to purchase investments and managed professionally. A mutual fund is the best way to get started because it removes much of the pressure when you first start investing.
How you can get started
At this point, you’re fired up about compounding interest. You want to harness this incredible power, but you’re not sure where to start. I’ll show you how to gain access to the eighth wonder and demystify most of the fancy investment language.
Open a Brokerage Account.
Now you need a brokerage account to have access to the stock market. A brokerage account is an arrangement made between an investor (you) and a licensed brokerage firm permitting the investor to deposit funds with the firm and place investment orders through the brokerage firm. (Credit: Investopedia) The account allows you to trade and purchase investments available in the stock market.
For most people, the easiest way to invest is through the 401k retirement plan at a company. If this option is not available at your company, you can set one up with a big brokerage firm. You can open an IRA, ROTH IRA or a taxable brokerage investment account.
For example, Charles Schwab, the company who maintains my brokerage account, allows you to open an account for free and charges no money to manage the account. I like that! They cost is only $4.95 per trade, but you can trade as much stock as you want in a single trade. Many other brokers charge similar fees.
Scenario Example: Suppose you have opened your brokerage account now. You have a sum of money to invest, let`s say $5,000. Now it’s time to choose your investments and watch them grow. If you have no knowledge of the stock market, you must seek the advice of a professional.
Seek professional investment advice.
There are also many people paid to give advice who are not very good at their job. If you have no ideas, the best place to find a professional is through Dave Ramsey`s website. Dave Ramsey is America’s personal finance guru, who provides leads to qualified professionals on his website.
As we discussed earlier, with carefully selected investments, if you’re 35 years with your $5,000, you will own well over $30,000 at 55 years old.
Conclusion:
Moreover, as you can contribute more and save more, there is no limit to the wealth you can amass through this amazing force known as compound interest. You’re in America; you want not to work and have the fat part of that pie to earn money.
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