The most powerful force in the world of investing is compound interest. In fact, Albert Einstein once called compound interest the “The eighth wonder of the worldBut what is compound interest? Why was it such a wonder to one of the most brilliant minds of the modern age? To understand, it’s best to break the concept down into practical explanations and math.
If you’re an investor, you need to know what compound interest is, how it works, and how to earn it. A big part of your wealth building opportunities come from compound interest. Here’s a crash course in compound interest and how to leverage it in your plans to generate wealth in the future.
The definition of compound interest
Compound interest is the continuous addition of interest payments to the principal balance. This starts a growth cycle where each time the interest accumulates, it is generated by a higher and higher balance. This is a definition best illustrated by an example.
Consider how much money you would have after 30 days if you start with a penny and double the principal each day. While you would still only have a handful of change at the end of your first week, by day 15 your balance would be $163.84. On day 20, it would be $5,242.88. And, by day 30, you would have more than $5.3 million to show for your composition. This example is one of the best to illustrate the power of compound interest, even if it is extreme.
The reality is that most interest is made up of a few percent at a time, over a longer period. For example, the stocks you own may pay a dividend of 2.15% each quarter. Or, your index fund may return 9% per year. The key factor in building wealth in this case is time. The more compound periods, the more it adds to the main balance and the higher the next compound amount.
How to Calculate Compound Interest
For those who prefer a mathematical look at the power of compound interest, there is a specific formula to calculate it: P(1 +r/n)NT. In this formula:
- P = the initial principal balance
- r = the interest rate
- not = the number of times interest is applied
- you = the number of periods elapsed
By investing standards, this formula is actually very simple. In most cases, the interest rate and the number of times interest applies are fixed, giving investors more control over other variables. You can continue to grow your main balance over time through reinvestment. And the longer you let your funds accumulate, the more this balance increases.
Examples of compound growth over time
Many investments offer capitalization opportunities. It’s about recognizing the different compound interest options and understanding how much and how often compound interest takes place. Here are some basic examples:
- Marcy invests in an S&P 500 index fund for 20 years, with an average return of 7% per year. Her starting balance of $5,000 and her monthly contribution of $250 will have grown to over $150,000 when she checks out again.
- Dalton owns shares of XYZ Company, which pays a 2% quarterly dividend. Over a five-year period, the stock itself grows by 50%. At the same time, Dalton reinvested dividends, which bought fractional shares and allowed him to grow his holdings exponentially.
Any investment that adds accrued capital gains to allow even more wealth generation is an example of compounding. Whether it’s stocks, bonds, funds or another investment vehicle, the goal is to grow the principal through return on investment, to generate even more income.
Want a more comprehensive look at the power of compounding? Discover our investment calculator and plug in your own investment numbers to see how compound interest affects your accumulation over time.
How to Maximize Composition
Whether it’s capitalizing through debt or equity, or a different form of investment, there are several ways to maximize its potential. Here are some of the best strategies:
- Time spent invested. The more compounding periods, the more accumulation per period. Translation: The longer you keep building the main, the more money it will earn.
- Continuous investments. Continuing to invest capital is a powerful means of accelerating accumulation. Not only will capitalization increase the return on investment, but also the continued contribution to the fund balance.
- Reinvestment. If your investment pays dividends or offers other reinvestment opportunities, grab them! Like the ongoing primary investment, these additional repayments will increase earning capacity.
- Optimal interest rate. The higher the interest rate (or rate of return), the more power money is added to the capital balance. Look for investments with a history of high interest rates.
There are dozens of other ways to optimize capitalization that are specific to investing. Look for ways to maximize the variables over which you have control: time, contributions, how you invest and more.
Capitalization is the key to wealth creation
Albert Einstein also had another quote about compound interest: “he who understands it, wins it; whoever doesn’t pays.” The concept is simple. When it comes to investing, compound interest works in your favor. If you are trapped in debt, each passing month makes your debt worse. This is why it is so important to understand compounding in the context of wealth creation. If you’re not on the safe side of compound interest, you’ll have to work hard to get there.
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What is compound interest? Apart from a tool for creating wealth, it is your driving force for security in the future. Taking the time to make smart investments that capitalize on compound interest will give you the peace of mind you need to grow your money. Then it’s just a waiting game as you watch your wealth pile up.