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While saving money is never a bad idea, investing allows you to earn not only interest on your savings, but compound interest.
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“Compound interest works by earning interest on the interest already earned,” said Khwan Hathai, CFP, CFT, founder of Epiphany Financial Therapy.
This leads to exponential growth, she said, meaning that even small initial investments can grow significantly over time, making it a powerful tool for wealth accumulation.
Hathai and other experts explain why compound interest is such a great way to build wealth over time.
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It Grows Exponentially
Compound interest is a fundamental tenet of finance that greatly facilitates your ability to accumulate wealth, according to Thomas Brock, CFA, CPA, an expert contributor for Annuity.org.
“The best way to illustrate compound interest, which grows exponentially, is to contrast it with simple interest, which grows linearly,” he said.
With compound interest, you earn interest on both your principal investment and previously accrued interest. However, with simple interest, you earn interest on only your principal investment.
For example, he said, assume you receive a $100,000 windfall and invest it in an interest-bearing vehicle that pays 8.0% interest annually for the next 20 years. With simple interest, your balance at the end of that 20-year period will be $260,000. With interest that compounds monthly, your balance at the end of that 20-year period will be nearly $493,000.
“Clearly, compound interest is a much more lucrative arrangement, and the differential grows over time. To maximize the power of compound interest and supercharge your savings, invest as early and for as long as possible,” Brock said.
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Start Investing Early
One of the keys to maximizing compound interest is to start investing as early as possible, Hathai said.
“The longer your money is invested, the more time it has to grow. For instance, someone who begins investing in their 20s can potentially accumulate more wealth by retirement than someone who starts in their 40s, simply because of the additional compounding years.”
Additionally, consistency in investing, such as making monthly contributions to a retirement account, can significantly enhance the power of compounding, Hathai said.
“Even modest regular investments can accumulate into a substantial sum over decades.”
She also recommended reinvesting dividends and interest payments rather than taking them as cash to dramatically increase the rate of compound growth.
“Investing in low-cost index funds and ETFs is often recommended for long-term growth,” she said. “These funds typically have lower fees and allow for diversification across a broad range of assets, which can reduce risk while benefiting from market growth.”
Understanding your risk tolerance and maintaining a diversified portfolio is essential in risk management.
Reaping the benefits of compound interest takes time and patience, Hathai said.
“It’s important to maintain a patient and long-term perspective, as the most significant growth in compound interest often occurs in the later years of an investment,” she said. “Short-term market fluctuations should not discourage investors.”
The longer the time frame, the more dramatic the results, added Andrew A. Lokenauth, a financial planner and owner of the finance blog Fluent in Finance. “For example, $5,000 annually invested over 30 years at a 7% average return grows to over $1 million.”
Set It and Forget It
Automate regular contributions from your bank account to your investments each month to make it effortless, Lokenauth said.
“Set it and forget it saves mental energy and ensures steady growth over the long run.”
The Rule of 72
Shawn Carpenter, chairman and CEO of Stock Alarm, uses what he calls “The Rule of 72” to explain the power of compound interest.
“Just divide 72 by your yearly interest rate, and voila-you have an estimate of how many years it’ll take to turn your cash into double cash,” he said.
Rolling in Dividends
To be really smart about compound interest, the idea is that you keep reinvesting the interest you earn, Carpenter said.
“If you invest in something that pays and reinvests those dividends, you’re turbocharging the compounding process. It’s like your money is having babies, and those babies are having babies, and so on.”
Mix It Up
Don’t rely on just one vehicle to grow your compound interest. Do it wherever you can, Carpenter advised — high-yield savings accounts; retirement accounts like 401(k) plans and IRAs; and a mix of stocks, like index funds.
Stay the Course
Remember that while markets will go up and down, it’s important to stay invested, Carpenter said.
“It’s the long game that wins with compound interest. Think of it as weathering a few storms to enjoy a lush garden later.”
Why settle for regular interest when you can compound it with very little extra effort?
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This article originally appeared on GOBankingRates.com: The Power of Compound Interest: Secrets to Long-Term Wealth Building