For example, if you have $500 and earn 10% interest per year, you will have $550 after one year. Then, if you earn 10% interest the next year on that $550, you end up with $605 by the end of year two. The process continues until, eventually, your original $500 may be eclipsed by the amount of interest you gained. This is one way many top investors find success in building their wealth. But it’s not just for the top investors—you can take advantage of compound interest through savings accounts and investment portfolios. Learn how to do that below.
What Determines How Much Compound Interest You Can Earn?
There are three main factors that can influence the rate at which your money compounds:
Compound Interest and the Time Value of Money
The foundation behind compounding interest is the concept of the time value of money, which states that the value of money changes, depending upon when it is received. Having $100 today is preferable to receiving it a few years from now because you can invest it to generate dividends and interest income. Compounding allows that money to grow. If you waited two years to receive that $100, you’d miss out on two years of opportunity to earn compound interest. This is known as opportunity cost. Opportunity cost is the loss of possible gains if an action is not chosen. In this case, the opportunity cost is equal to the amount of money you do not get in interest if you don’t invest in that money. In our earlier example, if you don’t invest the $500 in an account with 10% annual interest, you’ll lose the opportunity to earn $50 or more per year in interest. In 10 years, your $500 could be $1,296.87. But if you don’t invest it, it’ll still be $500 10 years later. When you understand the time value of money, you’ll see that compounding and patience are the ingredients for building wealth. Here’s another example: Let’s say you are 30 years old and want to have $1 million by the time you retire at age 65. You can afford to save $800 per month in an account with an 8% annual return on your investment. Will you be able to reach your goal? Using a compound interest calculator, you can see that you’d be able to turn that $800 per month into $1 million after 29 years—six years earlier than you plan on retiring.
Compound Interest Results Over Time
Another way to understand the power of compound interest is to put values into a compound interest table that shows you just how much your wealth can multiply over time. Imagine you’re an investor who sets aside a lump sum of $10,000. Take a look at the table below to see the influence of time and different rates of return on this investment. Over time, saving money is not the only key to a large fortune; compound interest plays a big part.
How Compound Interest Could Impact Teens and Their Savings
Your teenage years are a good time to start saving money for the future. Because you have time for that money to grow before you may need it to buy a house or retire, you can benefit greatly from compound interest. One easy way to start earning compound interest is to open a high-yield savings account and contribute a set amount to it every month. Over time. your money could grow a lot and allow you to build your wealth. While you may only be able to earn a small amount of interest in a savings account, the compound interest could add up over time. For example, if you contributed $50 per month to a high-yield savings account and earned 0.5% interest per year, you could have over $12,000 after 20 years. Once you’ve got the savings part down, you could try your hand at investing to potentially benefit even more compound interest. For example, let’s say you opened an investment account with the help of an adult (you usually need to be 18 years or older to invest). If you contributed $100 per month to the investment account for 40 years, and earned a 10% annual rate of return on investment each year, your money could grow to be more than $530,000.
A Higher Rate of Return Often Comes With More Risk
You may want to do whatever it takes to earn a higher rate of return on your savings or investments, but that can also be dangerous because higher rates usually bring higher risk. No matter how successful you are along the way, you’ll always want to avoid the possibility of losing more than a budgeted amount of the money you invest. To lower your risk, consider all your investment possibilities. You could start with a high-yield savings account, earning a decent amount of interest on that money year over year. There are also certificates of deposits (CDs) and money market accounts that offer you the chance to earn interest on your money. Stocks, bonds, exchange-traded funds (ETFs), index funds, and mutual funds are also investments to explore. Adding a variety of investments to your portfolio can help you diversify that risk and build your wealth through the power of compound interest.
