Compound interest, also referred to as interest on interest or Accumulated Interest is the ability for income to generate more income over time, as a result of reinvestments of interest earned. Simply put, compounding is a process whereby the interest rate is applied to the principal amount, or initial investment, plus all accumulated interest, thus creating interest on the interest earned.
Compound interest can be a great way to grow wealth over long periods of time. Lets look at an example that shows how compounding works over a 10 year period, assuming a 10 percent annual interest rate.
Starting with an initial investment of $1,000. The table below illustrates how compounded interest works by showing the compounded balance year-by-year.
Year 1: $1,000 x (1 + 0.10) = $1,100
Year 2: $1,100 x (1 + 0.10) = $1,210
Year 3: $1,210 x (1 + 0.10) = $1,331
Year 4: $1,331 x (1 + 0.10) = $1,464
Year 5: $1,464 x (1 + 0.10) = $1,610
Year 6: $1,610 x (1 + 0.10) = $1,771
Year 7: $1,771 x (1 + 0.10) = $1,948
Year 8: $1,948 x (1 + 0.10) = $2,143
Year 9: $2,143 x (1 + 0.10) = $2,357
Year 10: $2,357 x (1 + 0.10) = $2,592
Looking at the table above, it follows that after 10 years, the compounded balance will be $2,592 since it is the total compounded balance over the 10 year period. Its also worth mentioning that during this 10 year period, a total invested amount of $10,000 (10 x $1,000) must have been used in order for the compounded balance to reach $2,592.
Additionally, it is important to note that the greater the time horizon, the greater the compound interest effects. This means that the longer an initial investment is left to accumulate and compound, the greater the overall return on investment.
The beauty of a compounding effect such as this is that it requires no additional effort or investment on the part of the investor. So, a good strategy is to start investing early and contribute money as often as possible.
Compound interest has been called one of the greatest inventions of modern times, because it allows investors to compound the relative value of their investments over a long period of time, in order to enjoy a greater return on their investments than that produced by a simple linear increase.
There are multiple factors that will impact the power of compounding. These include the rate of return, the time the money is left to compound and the amount of regular contributions. Therefore, for someone looking to maximize their use of compounded interest to achieve significant growth, the following strategies should be employed:
1. Start early: Starting as early as possible is essential in order to maximize the potential of expected returns. With more time, larger returns can be earned as the compounding force really has the chance to take off.
2. Dedicate regular contributions: The more money that is contributed on a regular basis, the greater the compound return. For example, should an investor contribute $100 a month to an account earning 10 percent annually, the long-term returns of such an account can be stupendous.
3. Choose the right investment: An important factor is the selection of investments offered by an investment vehicle and the rate of return it may generate. Generally, the higher the rate of return, the higher the compound return at the end of the period.
4. Re-invest profit: Any profit generated should be re-invested back into the original investment vehicle to maximize the potential of the profits. This creates a snowball effect for compounding returns.
Overall, compound interest is a powerful financial tool that can help to generate efficient and consistent results over the long-term. With the power of compounding, a person can enjoy exponential growth on their investments.
