If you want to grow your wealth over time, there is one concept that you need to understand: compound interest. Compound interest is the process of earning interest on your initial investment and on the interest that you have already earned. In other words, it is interest on interest.
Compound interest can make a big difference in your savings and investments over the long term. For example, let’s say you invest $10,000 in a savings account that pays 5% annual interest compounded monthly. After one year, you will have $10,512.67 in your account. That’s $512.67 more than your initial investment. But after 10 years, you will have $16,470.09 in your account. That’s $6,470.09 more than your initial investment. And after 20 years, you will have $27,126.50 in your account. That’s $17,126.50 more than your initial investment.
The power of compound interest comes from two factors: the interest rate and the frequency of compounding. The higher the interest rate, the more money you will earn over time. The more frequently the interest is compounded, the faster your money will grow. For example, if you invest $10,000 in a savings account that pays 5% annual interest compounded annually, you will have $16,288.95 in your account after 10 years. But if you invest $10,000 in a savings account that pays 5% annual interest compounded monthly, you will have $16,470.09 in your account after 10 years. That’s $181.14 more than the first scenario.
Compound interest can also work against you if you have debt. For example, let’s say you borrow $10,000 from a credit card company that charges 18% annual interest compounded monthly. If you only pay the minimum payment of $200 every month, it will take you 94 months (almost 8 years) to pay off your debt. And you will end up paying $18,825.21 in total. That’s $8,825.21 more than what you borrowed.
Therefore, it is important to understand how compound interest works and how it can affect your financial goals. By taking advantage of compound interest, you can increase your savings and investments over time and achieve financial freedom. By avoiding or paying off high-interest debt, you can reduce your expenses and avoid financial stress.
