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The Magic Of Compound Interest

The Magic Of Compound Interest

Would you give up something today to get something better tomorrow? It's an age-old question that we all face on a regular basis. It's also the key to a financial concept known as compound interest. Let's talk about some of the things you need to know about compound interest.

What Is Compound Interest?

It's simply earning interest today on the interest that you earned yesterday. If you banked $100 a year ago and collected $2 in interest, you'd now have $102 earning interest. The interest that you'll earn this coming year on the $2 is compound interest. It's money self-replecating!

What Can Compound Interest Do?

While many people know what compound interest is, they aren't aware how powerful it can be. Taken over a short period of time compound interest isn't very impressive. So what if you earn interest on an extra two dollars?

It might not be important for one year, but if your money is compounding for decades it can make a huge difference. Especially if you're earning more than 2 percent on your investments (and I certainly hope that you are!)

For instance, if you take the long-term S&P 500 return of 10 percent your money would double every seven years. So your $100 today would be $200 without you adding a cent in just seven years. Or $400 in 14 years. Or $800 on 21 years. The power of compounding is clear.

Why Don't More People Take Advantage Of Compound Interest?

Perhaps it's because so many don't understand the power of compound interest. Or they don't realize how quickly time goes by.

When you're in your 20s or 30s retirement seems a long way off. When you're in your 40s and 50s it seems like it's too late to take advantage of compound interest. Neither one is true. If you're young you'll be 60 years old before you know it. And, if you're nearing retirement realize that if you enjoy average longevity you'll live well into your 80s.

There's also the matter of delayed gratification. For most of us it's hard to give up something we want today to get something better years from now. But that's what compound interest requires. You need to forget that new flat screen today to have money compound in your IRA for retirement later.

The Power Of Compound Interest

Suppose you invested $1,000 and were able to earn 9 percent. You never added to the account. In just 10 years it would be worth $2367, in 20 years $5604 and $13,268 in 30 years. Imagine what it would do if you added to the account regularly.

Anyone can benefit from Compound Interest

You don't need to be a big time investor to benefit from compound interest. It works just as well on the first dollar you invest as it will on a million dollar portfolio. In fact, compound interest is a wonderful tool to achieve that million dollar portfolio.

The Dangers Of Compound Interest

Compound interest is a double-edged sword. It's a marvelous tool, but if you don't use it properly it'll do lots of damage.

How so? Credit card debt is a prime example. Instead of earning interest on interest, when you owe the credit card company you're paying interest on interest. So the amount you owe keeps going up. That's one reason why they're happy for customers to make the minimum payment each month and often raise your credit limit if you approach it.

Remember that $1,000 we invested a moment ago. Suppose that you borrowed it instead. On your credit card. And you paid a typical rate of 15 percent. You'll need to come up with $150 just to pay the interest this year. If you carry that balance for 10 years you'll pay $1,500 in interest. To borrow just $1,000!

The Bottom Line Of Compound Interest

The difference between continually worrying about money and a comfortable life may not be as large as you think. Just moving from paying compound interest on your debts to having compound interest build your assets might be just a few dollars each month.

Whether you're an active trader or a buy-and-hold dollar cost averaging type of investor, the sooner you begin to use compound interest the more powerful it will be.

Posted-In: compound interestEducation Opinion Markets Personal Finance General Best of Benzinga


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