Last week we discussed The Secret to Saving for Retirement, which is that it is never too early. Next we are going to talk about compounding interest and how it can work for or against you. But first, lets understand what it is and how it works.
You have probably seen the term compound interest linked to credit card debt or perhaps from a savvy investor who knows how to use compound interest for their benefit.
In contrast to simple interest, compounding allows a principal amount to grow exponentially, in other words, a lot faster. It is interest that not only accrues on the initial principal but also on the already accumulated interest.
Lets say our friend Bradley were to put $250 per month and earned 8% interest. See the graph below to get an understanding of how his money grows exponentially overtime in comparison to the principal accumulating without any compounding interest.
So how do you make compounding work for you?
- Start early. Start now. – The younger you start saving money in an account with compounding interest, the more time compounding will work in your favor.
- Make regular contributions – As you can see in the previous example of Bradley, because he continued to put $250 away per month, the money continued to grow at a high rate. It is important to remain disciplined in your monthly or annual contributions once you start saving to get the most out of compounding interest.
- Be patient – Don’t touch the money that you have already contributed. Compounding only works if you allow your investment to grow.
- Maximize compounding periods – When looking at different retirement accounts to invest in, consider choosing one that has the shortest compounding period. The more often interest is paid, the faster your investment will grow.
- EARN interest. Don’t pay it. – Don’t forget that although compounding interest can create long-term wealth, it also can work against you. Typical credit cards charge interest rates at a high 20% on unpaid balances. Now imagine the previous example of Bradley earning 8% and how quickly the principal grew. Now imagine 20% but working against you.
By understanding the power of compound interest, you too can build wealth over time.