In order to manage your finances responsibly, you need to understand compound interest and how it works. Although you may not necessarily have to calculate compound interest, it has a lot of power in terms of your finances. Learn everything you need to know below!
If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.
What is Compound Interest?
Compound interest is the process of earning interest on your interest. Even though interest may seem small, even small amounts add up quickly when compounded—it’s the snowball effect in action. If a small snowball begins rolling down a hill, it gains more and more snow and becomes bigger and bigger. Even though the amount added to the snowball with each roll is relatively small, by the time the snowball reaches the bottom of the hill, it can be many times larger than when it started.
How Does Compound Interest Work?
The snowball effect may provide a helpful visual, but let’s look at an example to show just how powerful compound interest can be. Let’s say you invest $10,000 with an average interest rate of 7% (the historical annual average return for the stock market). Even if you make no further investments and simply let your money sit, what would happen? In five years, you would have $14,026. In ten years, you would have $19,672 (almost doubling your money). And in 30 years you would have $76,123.
Factors that Impact Compound Interest
As we’ve now seen, compound interest is powerful. In order to take advantage of its benefits and avoid pitfalls, it helps to understand the factors that go into making compound interest so powerful. This includes the following:
Frequency
The frequency is how often interest is calculated and could be daily, monthly, annually, etc. The more often interest is calculated, the bigger the impact. For example, if you have an initial investment of $10,000 that’s invested for twenty years at a ten percent annual interest rate, if interest is calculated annually, you’ll end up with $67,275. However, if interested is calculated daily, you’ll end up with $73,870.
Time
Time is what gives compounding interest its power. The longer the time compounding interest can accumulate, the bigger an impact it has. As we’ll see below, when investing, time can work in your benefit, but when it comes to loans, time is the enemy.
Interest Rate
Thanks to compounding, differences in interest rates that seem incredibly minor can have a huge impact, especially with major purchases, such as a house.
Size of the Principal
The principal amount obviously matters when it comes to calculating compound interest, but where people often fail to take this into account is deposits and withdrawals. For example, if you’re in your 30s and take money out of your 401(k), you may tell yourself that you’ll put the same amount back in later (including the ten percent early withdrawal penalty). But even if five years later you put the same principal amount in, you’ll end up with less down the road. That’s because during those five years that principal wasn’t earning interest. You’ll not only lose out on that interest, but all the compounding interest of that interest, as well.
Compound Interest and Investing
As we’ve seen, compounding interest can have a huge impact on investing. The best way to take advantage of compounding interest is to begin investing early. You may not have control over the market’s rate of return (the interest rate) or the frequency of the compounding, but you do have control over the factors of time and the size of the principal. That’s why the sooner you can begin investing the better. And, especially if you have a long time horizon, even small differences in periodic deposits can have a huge impact over time.
Compound Interest and Loans
We’ve seen how beneficial compounding interest can be, but it’s not all good. When it comes to investing, compound interest can work in your favor, but when it comes to loans, it can end up costing you more. If you have credit card debt, student loans, or a mortgage, compound interest will cause you to pay far more over the life of the loan. As a result, the sooner you pay off loans, the less you’ll end up paying overall.
Work with a Financial Advisor
We hope you better understand compound interest and how it works. To see how compounding interest impacts your financial plan, talk to a financial advisor at Good Life Financial Advisors of Mount Pleasant!
