Compound interest is a type of interest where the interest earned on an investment is added to the initial principal, so that the interest earned in the next period is based on both the principal and the accumulated interest from previous periods.
For example, if you invest $1000 at an interest rate of 5% per year, at the end of the first year, you would earn $50 in interest. If you leave the interest in the account, the $50 in interest would be added to the $1000 principal, and the account would be worth $1050. In the second year, interest would be calculated not just on the original $1000, but also on the $50 in interest earned in the first year, so the interest earned in the second year would be $52.50 and the account would be worth $1102.5.
The more often the interest is compounded, the more quickly the interest will grow. For example, if the interest is compounded annually, the interest will grow more slowly than if it is compounded monthly or daily.
Compound interest can be a powerful tool for growing wealth over time, especially when combined with regular contributions and a long-term investment horizon.
It’s worth noting that compound interest can also work in the opposite direction, resulting in debt growing faster, this is known as compound interest on debt and it’s important to pay attention to the interest rate and the terms of the loan before taking it.
The magic of compounding and how it can benefit you
Compounding offers several benefits, including:
- Growth: Compounding allows for the growth of both the principal and the accumulated interest, resulting in a higher overall return on investment over time.
- Time: The longer the investment horizon, the more time the investment has to compound and grow, resulting in a larger return.
- Regular contributions: Regular contributions to an investment account, such as through a 401(k) or an IRA, can take advantage of compounding, allowing for the growth of both the principal and the accumulated interest.
- Consistency: Compounding is consistent and predictable, which makes it easier to plan for and achieve financial goals.
- Compounding can be a great way to grow wealth over time and to reach long-term financial goals such as retirement savings and college savings.
- Tax benefits: Some investment vehicles, such as 401(k) plans and traditional IRAs, offer tax benefits that can compound over time, resulting in a larger overall return on investment.
- Compounding interest is a way to earn interest on interest, which can lead to a higher return on investment over time.
- Compound interest can also be used to pay off debt, by making payments that are more than the minimum due, the interest on the debt will decrease over time.
Overall, compounding is a powerful tool for growing wealth over time, especially when combined with regular contributions and a long-term investment horizon.
Explaining compound interest to your kid so that they can thank you one day!
Imagine you have a piggy bank, and every day you put some money into it. Now, every time you put money into it, the piggy bank gets a little bit bigger and heavier.
Now let’s say your friend has a piggy bank too, but instead of putting money in it every day, they only put money in it once a month. Whose piggy bank do you think will be bigger at the end of a year?
Yours! Because you put money in it every day, it has grown bigger and bigger over time. This is called compound interest.
With compound interest, you earn interest not only on the money you put in, but also on the interest you’ve already earned. This means that the more money you have in your piggy bank, the more interest you’ll earn, and the faster your piggy bank will grow.
So, if you want your piggy bank to grow faster, you should put money into it as often as possible and leave it there to earn interest. And that’s how compound interest works!
Your kid may respond by asking: “But what is interest?”
Interest is a little bit like magic, it helps your money grow.
Let’s say you have a dollar, and you want to save it in a special place, like a piggy bank. But you don’t want to just save it, you want it to grow, so you can buy something you want.
So you take your dollar to a bank, and they say they’ll give you more money in the future if you leave your dollar with them for a little while.
The bank will give you extra money, called interest, for letting them use your dollar for a little while. The longer you leave your dollar in the bank, the more interest the bank will give you.
Interest is like a reward for lending your money to the bank. It’s like the bank is saying “Thank you for letting us use your money, here’s a little extra for you.”
So, if you want your money to grow, you can put it in a bank or invest it, and it will earn interest over time.