Your Biggest Weapon in Savings is Compounding . . . So What is It?

Compounding is considered the most powerful force in personal finance.  Compounding is simply earning interest on interest. See the example and explanation below:

You Invest $10,000 and Earn 4% Every Year

You earn 4% interest on the $10,000 invested in year one, which equals $400 interest your money earned. In the second year, your 4% interest is calculated on the original $10,000 investment plus the $400, you earned in year one.

This produces an interest payment of $416 for the second year, which is then tacked on and included when calculating your interest for the third year. And so on and  so on. . . .

You may be surprised at how quickly this can add up. This compounding impact exist on loans and savings accounts.

How much and how fast your money grows depends on a few things:
1. Amount of initial investment
2. Interest rate earned
3. Any additional money added along the way
4. Number of years money is invested

For most people, the best option is to start with a smaller initial investment and add to it every month. That will result in a BIG WIN!

  • $5,000 invested at 4%, with you adding $0 per month for 10 years will grow to $7,401
  • $2,000 invested at 4%, with you adding $200 per month for 10 years will grow to $31,775
Let's say you have a child that's going to college in 20 years:

  • $2,000 invested at 4%, with you adding $200 per month for 20 years will grow to $75,850

  • Where you can earn compound interest?
    1. Bank savings account
    2. Certificate of Deposit (CD)
    3. Money market
    Those all allow you to take advantage of compounding, but the interest rate offered is low.

    Compounding also impacts stocks where dividends are re-invested, like an IRA or 401k. Compounding grows money faster in these cases because the rate earned is generally much higher.

    The best part about compound interest is that it works the same for everyone, whether you have $20 to invest or $200,000. Go ahead, tinker with this compounding calculator to see what I mean:


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