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Compound interest is interest calculated on principle and on previous years’ interest. To explain the power of compound interest a little better, let’s look at the following example:
Assume an initial investment of $1,000 that earns a 10% annual interest. Over the first three years, the amount of interest earned is calculated as follows:
Year 1: $1,000 x 10% = $100
Year 2: $1,100 x 10% = $110
Year 3: $1,210 x 10% = $121
The total savings after three years is $1,331 which is equal to the initial investment of $1,000 and the total of all the interest ($100 + $110 + $121 = $331). The $331 is the compounded interest.
The Rule of 72
The rule of 72 is a simple formula that estimates how long it will take to double your initial investment. Divide 72 by the expected average annual rate of return offered on your savings or investment account. The result is the number of years in which your savings will double. Simply take your interest rate and divide it into 72. If you have a 4% interest rate, 72 divided by 4 equals 18. So, it would take you 18 years to double your investment. For the example above using a 10% interest rate, your savings would double in 7.2 years.
The longer you save, the more interest compounds over time. It is better to start investing now so you can reap the benefits later.
Why Compound Interest Is Important
The secret of future financial success is to start saving as soon as possible. Even a small amount of money can generate wealth over time when compounding interest is involved. You might think compound interest doesn’t benefit you much, but when you consider a long-term investment even lower interest rates can significantly grow your investment over time.
Start saving as early as possible, preferably in your 20’s, to enjoy the benefits later on in life. Remember that it is never too late to start saving, but the sooner you start the longer you will have for your money to grow.