When managing your money, compound interest can help you increase your net worth safely. In its simplest terms, compound interest helps money multiply at an accelerated pace. Review this information and consider what works best for your situation.
What Is Compound Interest?
In basic terms, compound interest multiplies the total savings amount by the annual interest rate to give you a total amount earned over the course of the investment. You multiply your investment by the number of compounding periods. Some investments have more compounding periods than others, and some investments take a lot of time to mature while others move much faster. But, as interest compounds, how can you leverage this concept to improve your investment portfolio, retirement account, etc?
How Does Compounding Affect Your Savings?
Compound interest functions as a way that your money works for you when it’s just sitting there. For example, if you take $100 (your “principal”) and stick it under the mattress where it earns no interest, in 10 years you would have the same $100. However, if you were able to earn 5% interest compounded annually on that money, you’d end up with $162.89 at the end of 10 years, which is $62.89 more. If you’d started with $5,000, the resulting amount is $8,144.47 or $3,144.47 more. That’s a big difference in results when using compounding interest.
In today’s low-interest-rate environment — high yield savings accounts, money market funds, and short-term Certificates of Deposit pay under 1% in interest — finding a place that would actually pay you 5% in interest in 2022 without the risk of losing your principal is unlikely. Savers are unlikely to earn 30 years of risk-free, guaranteed 5% interest, but you get the picture of how compound interest helps you.
If the compound interest rate is changed to a more modest and realistic 1% compound interest rate over 10 years and you deposit $100, you’d end up with $110.46 if your money were compounded annually ($10.46 more). The $5,000 example results in $5,523.11 or $532.11 more. Even though the returns aren’t that great when you are earning 1% interest as compared to 5%, they result in you getting money that you wouldn’t have gotten if it sat in a jar. The additional amount earned at 1% isn’t nearly as satisfying as the higher rate of 5%, which is why investors today may turn to riskier financial vehicles like the stock market or corporate bonds for higher returns.
Thus, you must consider both the percentage rate of return and compounding frequency when opening a savings or money market account.
How Does This Financial Calculator Work?
A compound interest calculator tells you the amount of money you can expect to see after a certain period of time with a specific interest rate. It handles the calculation for you so that you can understand the return to expect.
You make a $1,000 initial investment: You can choose any amount you want. It’s never too late to start investing.
Contribute $100 to the investment monthly: You may also contribute in different intervals, different amounts and with different goals. The account might be part of a trust or your own account.
Over 10 years: You get to decide how long the contributions should last. Some people are saving for retirement, but others are saving for the nearer future.
At 3% interest compounded annually: Every investment is different, and it helps to know the sort of return you can expect.
In 10 years, you would have $15,100.57 if the interest rate stayed the same and you continued contributing at that rate: You would have contributed $13,000 and earned $2,100.57 in interest. Using the calculator helps you determine how much you can expect to see. Plus, you can choose terms along the way to understand how much money you would see if you stopped saving sooner.
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Compounding Interest Formula
A formula that tells you how much your principal balance will rise to (P’) based on the initial principal amount P appears below:
P’ = the new amount of principal
P = the original deposit amount or principal
r = the annualized nominal interest rate expressed as a decimal
n = how frequently interest is compounded per year
t = the number of time periods elapsed in years
The total amount of compound interest (I) generated by this investment is then equal to the new amount of principal (P’) minus the initial deposit amount (P):
I = P’-P= P(1+r/n)^nt – P = P((1+r/n)^nt – 1)
Use Compounded Interest to Improve Your Finances
Using compound interest to improve your finances is just one way to earn money for the future. Choose the most appropriate investments to grow your money in accordance with your personal risk tolerance, targeting your goals and providing you with the peace of mind that you rightly deserve. You can use a compound interest calculator that helps you see the total amount of money you can earn over a certain number of compounding periods.
Check out Benzinga for more financial information including savings accounts, stocks, crypto, interest calculators and much more.
Frequently Asked Questions
Can compound interest make you rich?
When you save with compound interest, you make your money work for you. However, saving with compound interest for a short period of time and at the low interest rates available in 2022 are probably not enough to help you build massive wealth.
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