Compounding is the process whereby interest is credited to an existing principal amount as well as to interest already paid. Another way to describe it is “interest on interest.” This effect will make a sum of money grow at a more accelerated rate than simple interest, which is calculated only on the principal amount. The greater the number of compounding periods, the greater the compound interest will be.
To understand simple interest, let’s assume you deposit $100 into an account with a 5 percent interest rate. Multiply your principal by the interest rate, and then the amount of time you expect to keep that money in the account. One hundred dollars times 5 percent, or 0.05, is $5. Keep that account going for 50 years, and you’ll earn $250 in interest, for a grand total of $350.
Now let’s apply compound interest to that same $100 at the same 5 percent interest rate. If that interest rate compounds each year, your $100 would turn into $1,146 at the end of 50 years. If you matched your initial investment of $100 each month, without changing anything, you’d end up with $252,364 after 50 years. Clearly, when used correctly, compound interest can help you turn small initial investments into small fortunes.
5 helpful tips to maximize the compound interest effect:
Start early if you can. The longer your money is invested, the more time it has to grow. When it comes to compounding returns, time is an advantage.
Contribute to your plan on a regular basis. Regardless of the amount, the important thing is to start and be consistent.
Increase your regular contributions. Each year, as you get a raise, try to increase your contribution, even if only by a small amount. It all adds up!
Put extra money into your plan if you can. If you get a tax refund, a bonus, or some birthday money, add all or part of it to your account for an extra boost.
Leave your money in your plan. The longer your money stays in, the larger the benefit you’ll receive.
By understanding and adopting these strategies and leaving your money to grow undisturbed, you can harness the full potential of compound interest and watch your finances flourish. We can help. If you have questions or need advice, we’re always here to help pave the way to a more secure future.
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