How to Use Compound Interest to Build Wealth
You’ve probably come across the term “compound interest” when considering savings and investment options. But what exactly is compound interest, and how does it impact your wealth-building strategy?
Compound interest is a powerful tool that can appear minimal at first, but when coupled with time, it can tremendously impact your savings journey. Together, we’ll explore this concept, explain how it works, and reveal ways to leverage its power to build wealth and secure your financial future.
What is Compound Interest?
When you invest money, the financial institution will often pay you interest (an amount for holding your money at their institution). You can either spend this earned interest or keep it in your account and let it grow or compound.
Compound interest refers to the interest calculated on the principal amount you invest plus the accrued interest from previous periods. In other words, it’s interest on interest. And it can create a snowball effect that can lead to substantial financial growth given enough time.
How Compound Interest Works
Interest is compounded on a schedule as determined by the financial institution. The most common compounding scenarios are daily or monthly, though some use quarterly or annual schedules.
To illustrate how compound interest works, assume you invest $1,000 at an annual interest rate of 5%. In the first year, you will earn $50 in interest, bringing the total account balance to $1,050. If you do not touch this money in the second year, you will not only earn interest on your initial $1,000 investment but also the $50 in interest gained from the previous year. This compounding process will continue, with each consecutive year’s interest contributing to the overall growth of your investment.
Time is Money
The phrase “time is money” comes to life when considering compound interest. Time is one of the most crucial factors that affects compounding interest. The longer you invest your money, the more time it will have to grow and compound. If you want to make the most of your investments, it’s best to start early.
The following example sheds light on the tremendous impact compound interest and time can have on your investments.
Example:
At age 25, Person A saves $500 per month for 10 years, earning 5% APY. Throughout this process, they do not touch their investment and let the balance compound. Then, they do not deposit any more money into the account – simply letting it compound until they turn 65.
- Total Investment: $500 x 120 months = $60,000
- Total Balance at 65: $346,880
- Total Interest Earned: $286,880
Person B begins saving $500 per month, earning 5% APY, when they are 35 years old. They continue this savings strategy until they are 65 – not touching their investment throughout the process.
- Total Investment: $500 x 360 months = $180,000
- Total Balance at 65: $416,129
- Total Interest Earned: $236,129
While Person B invested three times as much of their own money ($180,000 vs. Person A’s $60,000), their total earnings were about $50,000 less in interest. Person A benefited significantly from an extra 10 years of compound interest by starting their investment journey when they were 25 (versus 35 like Person B).
Leveraging Compound Interest to Build Wealth
Now that you understand how compound interest works, let’s explore how you can use it to your advantage to build wealth and significantly improve your financial future.
- Start Early: The sooner you begin investing, the more time your money can compound and grow. Even smaller contributions can lead to a significant balance with time.
- Be Consistent: Whether you contribute to your savings monthly, quarterly, or annually, keep your schedule consistent. Use tools such as payroll deductions or automatic transfers to put your savings plan on autopilot.
- Reinvest: Instead of withdrawing any interest earned, reinvest it to take full advantage of the compounding effect. Reinvested earnings contribute to a larger principal balance, resulting in faster growth.
- Be Patient: Avoid the temptation to withdraw funds prematurely. One thing you can never get back is time. So, if you withdraw a portion of your savings, you’ll be unable to recoup those potential earnings.
- Diversify: As your investment portfolio grows, spread your assets across multiple classes to minimize risk. A diversified investment portfolio can enhance overall returns and safeguard your wealth against market fluctuations.
We’re Here to Help!
Time is money, and compound interest proves great things come to those who wait. By creating a savings strategy and allowing your money to compound over time, you’ll pave the road to a secure and stable financial future.
If you have questions about compound interest or want to explore the various savings and investment options available, we’re prepared to help. Please stop by any of our convenient branch locations or call 1-800-531-8456 to schedule an appointment today.
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Each individual’s financial situation is unique. We encourage you to contact United Texas Credit Union when seeking financial advice on the products and services discussed. This article is for educational purposes only. The authors assume no legal responsibility for the completeness or accuracy of the contents.