Investing 101: Compound Interest

(It’s Tuesday, and you know what that means: Investing 101 day!  Today we look at compound interest, one of the most basic concepts in investing, and indebtness, for that matter.  So, for a closer view of the concept that Albert Einstein is said to have called ‘the most powerful force in the universe’, let’s journey together, shall we?)

Q: What is compound interest?

A: In a nutshell, compound interest is interest that is earned on interest.  For example, let’s say you have $100 in a bank account that earns 5% interest.  After one year, you will have earned a total of $5 in interest.  If you add no more money to the account, after the second year, you will have earned $5.25, five percent of your new total of $105.

Q: An extra $0.25; how’s that supposed to impress me?

A: It’s not where you start but where you end up that matters.  After five years, you’ll have over $120 in your account and be earning over $6 a year in interest (an increase of twenty percent).  After ten years, you’ll have $155 in the bank and earn nearly $8.  If you keep the money in there for thirty years, you’ll have $411 in the bank (more than four times the money you started with) and will be earning over $20 each year.  All of that is possible with a tiny starting balance and only a moderate level of return; if you start with $10,000 and get a 10% return (a frequently cited average for the return from the stock market), you will have nest egg worth $158,000 in thirty years, and will receive over $15,000 each year in returns, without investing another dollar.  Not a bad start to funding your retirement.

Q: Okay, that’s more exciting; are there any disadvantages to compound interest?

A: Well, yes.  While compound interest is your best friend when you have money in the bank, if you are in debt, compound interest can be a killer.  A debt of $5000 can grow to more than $10,000 in five years if you are being charged 20% interest on your debt (a rather low rate, among credit card interest rates).  If you’re paying only the minimum charges (usually only two to three percent of your outstanding total), there’s no way to ever get ahead on your debt.

Q: Alright, fair enough; how can I take advantage of compound interest, without letting it take advantage of me?

A: There are some pretty simple rules when it comes to your investments and debts so that compound interest works for you.  First, starting saving early, and consider putting aside a little more than you initially planned.  The three factors that determine how much you will gain in compound interest are the starting amount, the interest or return rate, and the time you allow the investment to grow.  How much you invest and how long you allow the money to grow are within your control.

Second, try not to be too cautious in your investments, especially when you are young. Look up stock symbols and learn the ones from companies you think will do well, even during hard times. It’s tempting, especially when the investment world seems to be falling apart (as it did at times last year), to flee to the safest investments you can find.  But, money market funds, Treasuries and even bond funds will all yield less over the long run than stocks or real estate.  Attempt to avoid the risk of falling account values, and you can find yourself facing the risk of not having enough to retire or meet your other needs.

Finally, if you owe money, do your best to pay off the debt by paying more money than you owe.  If you are paying only or predominantly interest, your debt will just continue to grow and grow.  Paying down some of the principle of your debts, be they your mortgage or credit card loans, will only save you money in the long run.

That’s all there really is to it; pay down debts (particularly the principle), give your money time to grow, and take some smart risks with your money as long as you have time to recover.  Do that, and compound interest will be your best friend (and will all but pay for your retirement).

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