For investors, there is unfortunately no magic wand or crystal ball that will lead to riches. But saving and investing wisely can open individuals up to something almost as powerful. It is called compound interest, and it is one of the surest ways to build wealth. All it takes is a bit of patience.
What is compound interest?
So, what is compound interest and how does it benefit investment accounts? Compound interest consists of the interest calculated on the initial principal including all the previously accumulated interest on the investment. Essentially, compound interest allows investors to earn interest on interest and multiplies wealth at an accelerating rate.
As an example, if an investor has $1,000 at the beginning of year 1, invests the funds and earns a 7% return on that investment, at the end of year 1, they will have $1,070. At the beginning of year 2, they now have $1,070, and if they earn another 7% on those funds during year 2, at the end of the year, they will have $1,144.90. Assuming they earn 7% on the investments annually, that initial investment of $1,000 will grow to $7,612.26 by the end of year 30 with no additional investment. By contrast, if the investments earned simple interest of 7% over the same 30-year period, the value of the initial $1,000 investment would grow to $3,100 by the end of year 30. This is because the annual growth in simple interest is based on the principal amount invested and not on the accumulated growth from previous periods. It is important to remember investment returns will vary from year to year, sometimes significantly, and that will also have an impact on the growth of investments.
As demonstrated in the example above, this application of “interest on interest” makes the amount invested grow much faster than simple interest. Other factors can play into the effect of compound interest including the impact of compounding periods on growth. A detailed explanation on compounding periods is beyond the scope of this discussion, but a basic guideline is the greater the number of compounding periods, the greater the amount of compound interest.
A key component of compound interest is time. Whether it is saving for retirement or for a child or grandchild’s education, time is a key element in utilizing compound interest. Investing and keeping those funds invested for several years can lead to significant gains over time. And generally speaking, the longer the funds are invested, the more growth the assets will see.
Let’s again take a look at the above example where an individual invested $1,000, earns 7% return on that investment and keeps the funds invested to grow to $7,612.26 by the end of year 30. If the individual invested those funds five years later, the money would have only grown to $5,427.43. If the investment was made 10 years later, the growth would only amount to $3,869.68. In fact, if the investment was made 10 years later, the individual would have had to make an initial investment in the first year of nearly twice as much ($1,968) to end with the same amount.
While there are no guarantees in investing, utilizing the power of compound interest and time is one of the best ways for individuals to put their money to work and significantly grow their wealth.
Authored by Dennis Culver, Insight Wealth Strategies
Insight Wealth Strategies, LLC is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Insight Wealth Strategies, LLC and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Insight Wealth Strategies, LLC unless a client service agreement is in place.
Insight Wealth Strategies, LLC (IWS) and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.