The Power of Compound Interest

Compounding is what happens when your interest earns interest, resulting in a snowball effect.

For example, if you start out with $100 and you compound annually at 10 percent, you'll have $110 by the end of the year. The second year you add $100 to the account and still earn 10 percent, but you earn it on $210, giving you $231 at the end of the year -- doubling the interest you earned in the first year. It doesn't seem like much at first, but over the long haul all that interest adds up.

Interest can be compounded annually, monthly or even daily, meaning you earn interest on whatever amount you have at the end of that period. Daily compounding gives you more money than annual compounding because your principal -- the amount that earns you interest -- increases every day rather than only once a year. The more frequently your interest is compounded, the more it will grow.

Compounding has more power the earlier you start investing. The following example will show you how.

The Power of Compounding

Say you invest $2,000 a year for 10 years from the time you're 22 until you're 32. Then you stop investing and let the money compound at 10 percent for 28 years until you're 59 1/2, which, depending on the type of account, may be the first time you can remove it without penalty. You'll have $505,629 after contributing a total of $20,000 and letting it compound.

On the other hand, if you wait until you're 32 to begin investing and you put away $2,000 a year for 28 years until you're 59 1/2, you'll only have $295,262, even though you'll have contributed a total of $56,000. Since money compounds more the longer you leave it in your account, it makes sense to start as early as you can.

Start Small but Be Consistent . . .

A great strategy for growing your savings is to commit to investing a certain amount per month. If you can invest $100 a month, for example, and commit to increasing your monthly investment by the rate of inflation each year (so if the inflation rate is 4 percent invest $100 a month the first year, $104 a month the second year, $108 the third year), your savings will add up quickly.

Think of the $100 payment -- or whatever amount you can afford -- as a monthly expense like your phone or electric bill. Put the payment into a money market account each month when you're paying your bills. If you invest $100 a month for five years and increase the monthly contribution by 10 percent a year, you'll have $9,278 assuming a 10 percent rate of return.

Five Steps to Making Your Money Grow

  1. Start investing as early as you can
  2. Get the highest interest rate, or rate of return, you can find
  3. Don't take the money out of retirement accounts because you'll be charged a penalty
  4. Try to make the maximum allowable contribution every year, even if it's not tax-deductible
  5. Leave your money in the account as long as you can after you've hit age 59 1/2; your money will compound more the longer you let it sit
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