The Power of Compounding

Every smart investor making money off of money has a secret they aren't telling you: compound interest. If you invested $10,000 today, and it grew 5% a year, that money would DOUBLE in 14.2 years! Read more to uncover the simple secret investors don't talk about.

What is Interest?

Jane and Sarah both earn $50,000 in their first year out of college. Jane puts aside $2,000 into her bank account while Sarah saves $10,000 of her salary. If their bank has a 5% interest rate compounding yearly, Sarah's one-time investment will become $20,000 in 14.2 years. For Jane, it will take 47.2 years for her $2,000 to turn into $20,000. This, my friends, is the power of compound interest.

To understand compound interest, we must first tackle the basics of interest. Interest is the cost of borrowing money, or the reward for saving it. In the context of compound interest, we'll be referring to the latter scenario. Essentially, interest on savings is is money a bank pays you as a "reward" for keeping your money in their account. It is calculated as a percentage of your balance. For example, if you deposit $1,000 into a bank account and your bank has a 5% yearly interest rate, you would earn $50 at the end of the year for just keeping your money in the bank account.

What is Compound Interest?

Compound interest is essentially interest earned on both your principle amount AND your past interest. Going back to the previous example, if you keep your deposit in the bank for a second year, you would earn 5% of your money back on the $1,050 instead of just the $1,000. Therefore, on the second year, you would earn $52.5 at the end of the year instead of just $50. While $2.5 may not seem like a lot, compound interest grows exponentially! The principle of earning interest on interest allows your money to grow faster and faster over time. The longer the money is left to compound, the greater the exponential growth.

What Does This Mean?

The overall message here is that you need to start saving early. If you put a small amount of money and leave it in the bank for your entire life, your money will have skyrocketed in that time. Since most banks use compound interest, it is important to choose a bank with a good interest rate. A good interest rate at the moment is currently 4% APY (Annual Percentage Yield) a year. Starting a retirement fund, education fund, and emergency fund are important things to start early, so that they can grow over time.

Conclusion

To quote Benjamin Franklin, "Money makes money. And the money that money makes, makes money." When thinking about what to do with your money, remember this principle. Compound interest is your friend, folks. Use it to your advantage.