The more money you save, the faster your balance grows. Compounding multiplies money at an accelerated rate. This means that the money you deposit today grows, then that new balance grows the next month and so on.
What is compound interest?
Compound interest is the interest on savings calculated on your initial deposit plus the accumulated interest from the previous deposit.
The power of compound interest makes money grow faster than simple interest, which is calculated only on the principal amount. The greater the number of compounding periods, the greater the compound interest will be.
How compound interest grows over time
In the early years of saving, it may seem like you’re earning only a modest amount of interest, but give it time.
Graphic courtesy of: wealth.visualcapitalist.com
How $25,000 can grow
Invested at an interest rate of 3.5%, compounded monthly
- If you deposited $25,000 in a high-yield savings account which compounded monthly at 3.50% APY, in 30 years you will have $71,332, without making any additional deposits. That means $46,332 would have accrued in compounded interest.
- Now imagine how much if you deposited an initial $25,000 plus an additional $100 per month compounded at 3.50% APY. In 30 years you'll have $134,873. That means $73,873 would have accrued in compounded interest.
Understanding compound interest
Earning interest-on-interest (compound interest) can be used with several different investing vehicles:
- Savings account
- Money market account
- Certificate(s) of deposit
- Investing in the stock market through dividend-paying stocks or mutual funds
Growing your money over time is the strategy of compound interest no matter where you choose to put your money. The longer your money is held or saved, the stronger the potential of it growing over time.
Rate of return plays a key factor
The annual percentage yield (APY) is the annual rate of return on an investment that includes the effect of compounding interest. The higher the interest when it comes to your savings, the better chance it has of earning more money on your initial deposit and accrued interest. Online high-yield savings accounts often earn customers more interest than larger banks with lots of branches.
Compounding period frequency, which is how often the interest compounds, can impact the growth of your money over time. Interest can compound daily, weekly, semi-annually or annually; and, the more often it compounds, the faster an account will grow.
Using the example of 3% interest, if we were to use annual compounding, you would simply add 3% to the principal once per year. On the other hand, semi-annual compounding would involve applying half of that amount (1.5%) twice a year.
Save regularly to get the biggest boost
If you want to build wealth, you need to start saving early and often. That's because compound interest works overtime. It's easy to forget how much money we're earning every year, even though we're only paying back what we've already borrowed. So, if you want to see your investments grow faster, you should start investing