Understanding The Power of Compound Interest

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Interest is a percentage of money deposited or loaned that is received by the lender or depositor.

In essence, it is paid in return for use of that money over time. Interest is most often calculated on an annual basis, but can be calculated for longer or shorter periods of time.

For many people, interest is a great incentive to save money. The percentages are often modest, but they can add up over time.

That’s not even the best part. What many people don’t realize is that thanks to compound interest, your savings can earn you more money over time. 

Simply put, compound interest is your interest income earning more interest on itself. This leads to your money increasing over time.

An Example of Compound Interest

Imagine that you open a savings account that earns 5% interest.

You deposit $100. When the time comes, your bank pays you $5 or 5% in interest. This is payment for you allowing them to use your money. 

Now, you have $105. The next interest payment will then be $5.25, giving you $110.50. After that, you will be paid $5.52. Every interest payment is bigger, because you are earning that 5% interest on a larger sum of money.

The example here, may seem small. It would take a long time for $100 to add up to much, even with compounding. Now, imagine that you save $10,000.00 at 5% interest.

Even if you never added another penny to your principal, in ten years that $10,000 would be over $16,000.

Things That Impact Your Compound Interest Income

The first thing that will influence the amount of money you earn in compound interest, is the interest rate.

Obviously, the higher your interest rate, the more compound interest you will earn…sort of. In reality, it’s a bit more complicated. 

Interest is often tied directly into the amount of risk you are willing to take on, and the amount of money you have to invest up front. So, a savings account with  no minimum balance might earn less than 1%.

A money market account with a $10,000.00 minimum could pay 5%.

Finally, a mutual fund where you take on the risk of investing in stocks could potentially pay a very high interest rate, and your profit would be paid out via dividends or capital gains.

The next influencing factor is time. One of the best ways to enjoy the benefits of compound interest is to simply contribute money over as long a period of time as possible, letting the interest compound over the years.

Finally, you have to consider taxes. All income is taxable. This includes interest income. However, you can save on your tax liability by investing in certain funds that reduce or delay your tax obligations.

For example, 401K savings are paid out of your check before any income tax is deducted. Further, any interest income you earn on that savings is also not taxed, nor is compound interest.

This remains the case until you begin withdrawing those funds in retirement.

Look into IRA accounts, SEP, and 401K if you want to save money and earn interest over time.

How do I Earn Compound Interest

First, you have to place your money into investments where this is possible.

This means any accounts where interest payments are made repeatedly over time, as long as your account is funded. You can earn compound interest through various savings accounts, retirement plans, CDs, IRAs, and other investments.

All of these can be funded with existing savings, payroll deductions, and other methods. The key to earning compound interest is in selecting how you want your interest paid.

In most choices, you can have your interest paid out to you directly, have it added back into the originating account, or have it deposited into another account. You have to take the second option in order for compounding to occur.

You can opt to have your interest deposited back into your account when you open that account. In many cases, you can also opt to change your interest payment method by simply contacting your bank or credit union. 

Compounding Without Interest

The principle of compounding doesn’t just come into play when it comes to interest bearing accounts.

It works with other investments as well. Imagine that you participate in a program at your office that gives you the opportunity to purchase company stocks at a discounted rate. 

If you opt to have your dividend payments reinvested in buying more stocks, you’ll earn higher dividends because you own more shares. Invest those dividends again, and that increases over and over.

Of course, as mentioned above, there are definite risks. Still, it’s important to know that over time, investing in funds, and reinvesting your dividends is a pretty reliable way of using compounding to grow your nest egg.

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