Compound interest is one of the most intriguing concepts in financial management. Although it can be beneficial for savings and investment purposes, it can also be detrimental if applied to a loan. You’re more likely to enjoy its benefits if you have good credit. Compound growth also increases your net worth more significantly if you keep reinvesting your returns. The more time you dedicate, the higher your growth potential.
With debit cards, you only use the amount in your checking account unless you have an overdraft. Credit cards help you build credit, have better protection against fraud, earn rewards, and provide access to short-term financing. However, most credit card issuers compound your interest daily. Consequently, the longer you go without paying off this debt, the bigger your financial burden becomes.
What is Compound Interest?
This concept refers to the interest you earn on both the principal and previously-received interest. For example, if you invest $100 for three years with 10% interest per annum, you’ll receive $10 in the first year. If you add it to the principal amount, the total will be $110, meaning you’ll earn an interest of $11 in the second year. Your new total will be $121, which will attract $12.10 for the third year of investment. Your total compound interest for the three years will be $33.10.
Compound interest is remarkably different from simple interest, which only charges a fixed percentage on the principal. Using the above example, you’d earn $10 in each of the three years using simple interest, or a total of $30. This amount is lower than the $33.10 compound growth.
When You Start Saving is More Important Than How Much
Time is the magic ingredient when it comes to compound interest. The earlier you begin, the more likely you are to reap the long-term benefits. No matter how small the amount is, the compounding effect will increase it to a sizable fortune.
Let’s use the $100 example at 10% yearly compound interest. By the third year, you’ll have earned $33.10 total interest. By the fifth year, the principal plus interest will be $161.051, which will rise to $214.36 by the end of the eighth year. The more time you dedicate to your investment, the faster and higher your compounded figure grows.
How to Get Started
The following investment and savings options can help you achieve financial freedom by utilizing the concept of compound growth:
1. Roth IRA
This retirement plan is funded with after-tax dollars, meaning you won’t pay tax when you withdraw your contribution. The interest you earn annually also earns more interest in consecutive years through compounding.
Unlike a Roth IRA, pre-tax dollars fund traditional 401(k)s. Your employer can also boost your long-term savings by offering to match your monthly contributions. They also grow through compound interest earned from investing in stocks and reinvesting your dividends.
3. SEP IRA
This individual retirement account (IRA) is suitable for self-employed individuals or small business owners. It’s more attractive if you have few or no employees. That’s because the IRS will compel you to contribute on behalf of eligible personnel. A SEP IRA allows a maximum contribution of $6000 per year.
4. 529 plan
This plan allows you to contribute towards future education costs. Withdrawals must go towards select education expenses, or they’ll attract income tax and penalties. The earlier you set it up for your child, the more you’ll have to withdraw when they go to college.
5. Low-Cost Index Funds
These funds offer diversified investment options while charging low fees. Their primary advantage is the power of compound interest that increases your holdings over time. You can either choose to buy stock index funds if you’re younger or bond index funds if you have a low-risk appetite.
6. Automated Investing Services
These digital solutions help you invest through algorithms that trade based on variables such as your age, risk tolerance, and income. Also known as robo-advisors or auto investors, they take away the tedious task of micromanaging your portfolio. You can reinvest your earnings and grow your investment through compound interest.
As you’ve figured out with all the above investment and savings solutions, time is of the essence. No matter how small your initial contribution is, it will grow significantly depending on how early you start.
How a Professional CPA Can Help
While you can participate in most of these plans as an amateur investor, a professional CPA will help you make wiser financial decisions. They have a better understanding of the elements that influence the amount of interest you’ll earn. Other than the time period, such factors include account fees, the interest rate, the amount in your account, and the tax rate. The amount you pay your financial advisor will be more than worth it in the long-term.