6 Things You Should Know About Compound Interest

Compound-Interest.1

There are so many helpful things one should know about compound interest and how it can work in your favor when saving for retirement or a rainy day fund. This investment tool can help you grow your money faster than if it was just sitting in a bank account, so be sure to learn all there is to know about compound interest before you make your next investment!

1. How It’s Calculated

When it comes to compound interest, you’ll want to know how it’s calculated. Essentially, the calculation is done by taking the principal amount, or the initial investment, and multiplying it by the annual rate of return. Then, that number is divided by 365 (the number of days in a year) to give you the daily rate of return. Finally, that number is multiplied by the number of days in the period you’re interested in to calculate the compounded interest for that period. Additionally, you can check out a Sortter compound interest calculator and do the job even easier. All you need to know are the parameters you need to put in the calculator. 

2. Earning Potential

The earning potential with compound interest can be huge! For example, if you invest $1,000 at an annual rate of return of 10%, your investment will grow to $2,610 over 10 years. But if you reinvest your earnings each year, your investment will grow to $67,274 over the same 10-year period. That’s a difference of over 4,600%. Also, if you save regularly and invest your money, you could become a millionaire sooner than you think!

3. The Rule of 72

The rule of 72 is a helpful way to estimate how long it will take for your investment to double given a certain rate of return. To use this rule, simply divide 72 by the rate of return. For example, if you’re earning a 6% annual return on your investment, it would take approximately 12 years for your investment to double (72/6 = 12). 

4. Compounding Frequency and The Time Value

Compounding frequency refers to how often interest is paid on an investment. The most common frequencies are annually, semi-annually, quarterly, and monthly. The more frequent the compounding, the faster your investment will grow. Also, if you’re reinvesting your earnings, be sure to reinvest at the same frequency so that you’re not missing out on any potential growth. The time value of money is an important concept to understand when it comes to compound interest. Essentially, the time value of money states that a dollar today is worth more than a dollar in the future. This is because a dollar today can be invested and will have the potential to grow over time. 

5. Tax-Deferred Accounts

When you invest in a tax-deferred account, such as a 401(k) or IRA, you don’t have to pay taxes on the earnings generated from your investment until you withdraw them. This can be a huge advantage, as it allows your money to grow faster than if it were in a taxable account. These accounts also have the potential to lower your taxable income in the current year, which could result in a tax refund or lower taxes owed. To create such an account, start by speaking with your employer or financial advisor. Then, decide how much you want to contribute each year and select an investment option that best suits your needs. After that, you just need to make sure you’re contributing regularly and let the account grow! 

6. Compound Interest is Your Friend

When used wisely, compound interest can be an investor’s best friend. By reinvesting your earnings and letting them grow over time, you can watch your money balloon into something much larger than what you started with. Compounding is often referred to as the “snowball effect” because it has the potential to grow your investment rapidly. The reason for this is that compounding allows you to earn interest on your principal investment as well as on any previous interest that has been earned. Also, the earlier you start investing, the more time your money will have to grow. So, if you’re not already taking advantage of compound interest, now is the time to start!

Compound Interest

Compound interest can be a powerful tool to help you reach your financial goals and grow your money faster than if it was just sitting in a bank account. Be sure to learn all you can about this investment before making your next investment. With compound interest, you have the potential to become a millionaire sooner than you think! I hope this article has helped you better understand compound interest and how it works.

The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.