The Wonders of Compounded Interest

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There are plenty of rewards that come with the patient investing of your money. The best, though, might be compound interest.

You might have heard that term previously. You might even know that compound interest helps your money grow faster. However, you might not realize how powerful compounding is and how much more quickly your savings can grow thanks to the financial miracle that is compound interest.

Here's a brief primer on how compound interest works, and why it pays to leave your savings untouched for as long as you can.

How it works

In its purest sense, compounding is what happens when you generate interest earnings on reinvested earnings. Effective compounding requires two things: You need to re-invest the money you earn on your original dollar investments. You also need to be patient enough to give your money time to grow.

Here's an example of how compound interest works. Say you invest $5,000 in an account that pays 6 percent interest annually. After one year, that account, thanks to interest, will have $5,300. If you leave that $300 you earned from interest in your account and kept it there for another year, your interest will compound. Your $5,300 will generate additional interest and turn into $5,618 at the end of the second year.

That is just the beginning. If you keep that extra $618 in your account for another year, your account balance will jump to $5,955.08. This means that you will have earned more than $955 without doing any work. You can imagine how if you keep your money in your account long enough, you will steadily grow your balance.

The key is that every year, a greater number of dollars are earning that 6 percent interest. This means that your balance will continue to increase as time marches on.

Look at it this way. If you invest $15,000 at an interest rate of 5.5 percent at age 25, thanks to monthly compound interest that investment will stand at $59,140 by the time you hit 50. That is without you making any additional deposits in your account. The difference between what you originally invested and what you have at age 50 is all a result of compound interest.

Boosting Compounding

If you want compounding to work more efficiently for you, though, you need to invest regularly in your account. That means adding to your account balance with additional savings on a periodic basis.

If you do this, and let compound interest do its thing, you'll be surprised at how quickly a small investment can turn into a large one. Of course, you have to leave that money alone and allow it to grow. If you keep removing dollars to help with emergency expenses or your regular bills, you'll sap much of the power out of compounding.

There are three simple steps to letting compound interest work for you: First, start slowly. You do not need to make a massive initial investment. Secondly, be patient. Keep your money in place and watch it grow. Thirdly, make regular investments in your fund. Every extra bit of money you add to your account will grow at a compounded rate, too. That can quickly add up to big savings.

Using the same $15,000 starting point as above, by adding $100 per month to your account for the same 25-year period will result in an ending balance of $123,638. By adding only $100 per month, you’ve more than doubled your money!