Do you like free money? What about increasing your wealth over time by doing absolutely nothing? I figure that your response to both is yes and yes. Well, I am here to tell you about the so-call eighth wonder of the world, “compounding interest.” It is simple, very logical and does not take much to understand or implement as part of your financial toolkit. In many cases, it is automatic. It is the reason why you should start saving and or investing early, and the reason it is never too late to get on the right financial track. By understanding compounding interest today, you can be financially secure tomorrow.
What Is Compounding Interest
Compounding interest is the addition of interest to the principal sum of a loan or deposit. In the context of saving, this is the reason why it is so important to start saving and or investing early. In its simplest form, it is interest upon interest. It is a beautiful thing when you are saving and investing. However, compounding interest can be detrimental if you are in debt.
Compounding Interest As An Asset
As an example, if you earn 8% return on your savings/investment on a yearly basis, after the first year you will have a total of your initial amount plus 8% of that initial amount. If you began with $100, you will have $108 at the end of year 1. However, look at what occurs over time. At the end of year two, you will have the amount at the end of year 1 plus 8% of that amount. Essentially, you have earned interest upon interest. In our example, you would now have approximately $116 at the end of year 2. At the end of year 3, 4 and 5, you would have approximately $126, $136 and $146 respectively. In 5 years, you would have earned $46 just by saving/investing.
Imagine if over that 5 year period you continued to save and or invest to grow your principal. Your return would be significantly more. Compounding interest is the reason why someone who saves and or invest at the age of 25 to 35 and stop will likely have significantly more for retirement than those who invest significantly more from 35 to 55. Compounding interest is the reason for a number of sayings, for example “it is not timing the market, it is time in the market.” With compounding interest, time makes all the difference.
To drive this point further home, in our example, in 20 years your $100 principal would turn into $466. If the total after 10 years is not impressive enough, in 50 years, your return would be a whopping $4,690. This total is from having $100 growing without contributing anything additional. Crazy isn’t it? Check out the US securities and exchange commissions’ Compounding Interest Calculator. Play around with the numbers, and see what happens when you not only save/invest, but also continue to do so over time.
Compounding Interest As A Liability
In the context of debt, compounding interest is the reason why it is so important to eliminate debt early. It is the reason why your student loan balance increases while you are still in school or in forbearance. It is also the reason why you hear so many stories of folks who have been paying down debt for years and have made no progress. How do you pay minimum payments on a debt for 10 years and still owe more than the original amount? The answer is simple, the answer is compounding Interest.
The interest rate on your debt matters, and so does the time that you take to pay it off. Compounding interest is why you are typically advised to pay more than the minimum payment on debt. The faster you pay off your debt, the less time there is for the interest to compound, the less total debt you will have to pay.
Your Advantage
Now that we have tackled the issue of what is compounding interest, to have compounding interest work to your advantage, pay down debt and begin saving and or investing today. The sooner you begin to save, invest, and pay down your debt the better financial position you will be in. Compounding interest is often called the eighth wonder of the world because once the momentum begins, it is hard to stop. For better (when you save and invest) or for worst (when you are buried in debt).
Our discussion should give you the imagery of a snow ball building in size. The snow ball begins small. When small, the snowball is insignificant and can easily be stopped and disposed of. However, over time, as the snowball continues to roll downhill and adds layers, it becomes a monster that cannot be controlled or stopped. That is compounding interest, use it to your advantage and achieve your financial goals.
Begin small, be consistent, and build over time to become financially unstoppable.
Conclusion
We all love simple and beneficial concepts that can be easily integrated into our life. Compounding interest is simple, very logical and does not take much to understand or implement as part of your financial toolkit. In many cases, it is automatic and works like magic. It is the reason why you should start saving and or investing early, and the reason it is never too late to get on the right financial track. By understanding compounding interest today, you can become financially unstoppable tomorrow. Journey to financial independence.
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