June 23, 2024

How Compound Interest Works

What Is Compound Interest?

Compound interest is a powerful force that you must understand in order to build wealth. Compound interest is when you keep making interest on what you already have. As the amount of money grows, so does your final outcome.

An example of compound interest would be if you were given
$1,000 and were paid 10% interest every six months. At the end of the first year you’d have $1,100; by the end of the second year you’d have $1,210.10; and by the end of three years you’d have $1,331.16—all without doing anything else.

How Is Compound Interest Calculated?

Compound interest is based on two variables: time and the interest rate. Usually the rate is based on an annual total. You may see something like a 2% annual percentage rate (a.p.r) on a savings account. That means every year you will receive 2% interest on your total priciple amount. This is normally paid out in prorated monthly amounts.

Meaning if you had $1000 and a 3% apr then you would expect to receive $20 in a year. But since this is calculated and paid out monthly you instead receive $20/12 for the first month’s payment, so $2.50. Often the amount is calculated daily based on your total and paid out monthly.

This is where the magic of compound interest happens. In month 2 you will no longer be receiving interest on $1000, but on $1002.50 which equals $2.51. Granted it’s a small difference in this example but it illustrates the point. Without doing anything the amount you make each month increases.

Scale up these numbers and it will make a huge difference to how much money you are making each month. And, if you aren’t withdrawing the number continue to just get bigger and bigger.

How Does Compound Interest Work To Build Wealth?

Use a compound interest calculator to see what kind of impact this can have on your wealth building. You take the amount of money you have invested and multiply it by the interest rate. This yields the future value or what you will have at the end of that time period. You can then use this to figure out how much interest you’ll make in that time period. Play around with the number and see what kind of interest rate and time period you need to get to a million dollars. It’s usually pretty inspiring and motivating.

Best Ways to Utilize Compound Interest for Your Savings Goals

If you are currently saving, then it’s likely you’re already utilizing compound interest. If not then I’d suggest utilizing your bank’s savings account or even a high yield online savings account. Either way they are typically increasing the amount of money that gets compounded. This is called a compound interest rate.

I highly suggest taking advantage of online banking as it makes calculating the interest very simple (especially if you’re used to using a compound interest calculator).

Final Thoughts

Hopefully this article will encourage you to utilize compound interest for your savings. It’s not any different than investing in the stock market (or other similar investments), but it is a very powerful way to build wealth.

As always, feel free to let me know below if you have any questions on compound interest and I’ll do my best to help. Happy saving!

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