Compounding interest can be your best friend. A simple definition of compounding interest is allowing your money to make more money. It definitely doesn’t take a financial wizard to understand how to benefit from compounding interest. The basic theme of compounding interest is when interest is continually added to the principal investment. As interest is added to your principal investment, it will begin to earn interest as though it was a part of your original principal investment. This is commonly known as “compounding interest”.
Let’s start with a basic example. You invest $1000 in a bank account where the bank offers an interest rate of 20% that is “compounded annually.” At the end of the first year, the account would contain the original principal of $1000 plus 20% of the principal, which is $200. This brings the balance of your investment to $1200. Now the true benefit of compounding interest will begin to appear. Going into the second year, the full $1200 is now considered to be your principal. Compounding interest will be calculated based on the new balance of $1200 as opposed to your original $1000 deposit. Therefore, at the end of the second year, compounding interest on $1200 will now earn you $240. The balance of your investment after two years is $1200 plus $240. Your original $1000 investment is now worth $1440.
Basically, compounding interest provides a way for your money to work for you. While $1000 is a decent investment, let’s consider a bigger picture. Consider a beginning investment of $50,000 with a 10% interest rate compounded annually. After the first year, your $50,000 principal investment would earn $5000. This will bring the new balance of your investment to $55,000. After five years of 10% compounding interest, the balance of your investment would now be $80,525.50. After 10 years, the balance of your investment would be $129,687.12. After 20 years, the balance of your investment would be $336,375.
Everyone works hard for the money they earn in their lifetime. It is only fair to expect your money to work as hard for you as you worked for it. Start compounding your interest today!