When dealing with investments, the number one phrase you’re likely to hear is “compound interest.” With the potential to transform only a few dollars into many, virtually anyone can benefit from investing any amount of money. But there is a trick to getting the most out of the process, and it’s important to understand that compound interest can also work against you — turning just a few of your dollars into many…for another company.
That said, once you know how compound interest works, make it work in your favor.
According to Investopedia, compound interest can be regarded as interest on top of interest. Basically, it works off the principal amount, taking a percentage of the total and adding it to the starting balance. Then, the next time interest it’s calculated, it’s based on the sum of the previous balance and the interest that balance earned. To illustrate, if you were to start with a principal amount of $100 that earned a compounded interest of 2% a month, you’d have $102 after the first month, $104.04 after the second month, and $106.12 after the third.
This is different from simple interest, which only allows you to earn interest on the principal amount, time after time. With a simple interest rate of 2% a month, you’d start with $100 and just continue to earn $2 a month, leaving you at $106.00 three months down the road, rather than $106.12.
In the long run, the difference between compound interest and simple interest can mean thousands of dollars.
Keep these tips in mind when working to increase your earnings with compound interest:
- – Any amount you add to a compound interest account will benefit you. Don’t worry if it’s just a dollar at a time. Over the long haul, that dollar will still make you more money than if it were left in your wallet.
- – Leave your money in your compound interest account as long as possible. The longer it’s in there, and the more you can add to it, the faster it will multiply.
- – Consider accounts such as traditional IRAs, Roth IRAs, 401k’s, and the like when you’re ready to invest. These options allow you to pay taxes on the amount of money you’ve earned less often (if at all) than at the end of each year.
- – Be careful in situations of debt, where the money you owe is compounded. Never pay just the minimum amount that’s due on your credit card statements. The compounding interest on what you owe will keep you in debt forever. To move toward freeing yourself of these kinds of debts, work to pay off more than the minimums, as quickly as possible.
Reap the benefits by investing as much as possible at as high a compounded interest rate as possible, for as long as possible. You’ll end up watching your money multiply and come to understand why Albert Einstein referred to compound interest as the “eighth wonder of the world.”
For more information on how to make the magic of compound interest work for you, or to strategize as to how to relieve yourself of debt and avoid financial traps, contact Fundamental Finance Academy — that’s what we’re here for!