Compound interest is calculated by combining the initial principal of a loan with its previously accumulated interest. When prior interest is included in the balance of the loan, the interest is essentially reinvested, generating higher yields as time passes.
Financially literate investors utilize the concept of compounding interest to accumulate wealth over time, and it can be beneficial for newer investors to master this concept. You may be wondering: What makes compound interest so powerful? Well, read on to discover the factors that make compounding interest a tool for creating wealth.
Time
The critical factor that makes compound interest so powerful is time. This concept is often referred to as the “time value of money.” If you invest some cash and leave it untouched for years in an account that compounds interest, the amount keeps increasing even if you don’t add any more money.
It is never too late nor too early to start an investment with compounding interest. Compound interest will favor you if you start sooner. For example, if you invest a fixed $1,000 in an account that compounds interest annually at 10% and check the account after two years, it will have approximately $1,210. However, if you put the same amount in an account paying 10% simple interest per annum and wait for two years, the total amount will be $1,200. This comparison shows that compounding interest is more powerful than simple interest.
Compounding Period Frequency
Another critical factor impacting the power of compounding interest is the frequency of compounding periods. This will determine the rate at which the compounding interest accrues. If your investment has short compounding periods, the accumulated compound interest will be greater. For example, if you invest $200, the amount of interest that will accrue compounded at 10% semi-annually will be greater than the same amount compounded at 20% annually. The shorter the compounding periods, the greater the interest over time.
Consistency
Compound interest is advantageous if you invest consistently over time. If you keep adding small amounts of cash to a $500 investment account that compounds interest at 10% annually over two years, you will be in a better financial position than someone who invests a fixed $500 and never adds more funds. Determine how often you will be adding money to the account and let the compound interest work for you.
A Worthwhile Financial Tool
Compound interest may set the boundary between struggling financially and having financial freedom. As detailed above, compound interest can be a powerful tool if you start early, invest in accounts with shorter compounding periods, and are consistent with your deposits. Once you understand how compounding interest works, you can take advantage of the concept to your benefit.