Compound interest can help you create wealth over time in a legal manner. Learn more about how to earn more money and be rich using the power of compounding.
If someone asked you about the most common concept in the financial sector- what would your answer be? Terms like compound interest will surely strike your mind. While the term might appear to be as simple as ABC for most of us, its significantly outlined intricacies are something not everyone knows. In this article, we shall look at all those aspects and ways you can build wealth over time using compound interest.
What exactly is Compound Interest
One can simply compare compound interest to a rolling snowball. Atop a hill, it starts with the size of a golf ball. Then, as it rolls, it accumulates more snow and becomes a giant ball at the end of the hill. Same way, compound interest is a mechanism in which your money earns interest not just on your initial investment, but on the interest that you are accumulating over time as well. This creates a compounding effect and amplifies your wealth-building efforts. On the flip side, the same compounding effect can occur on your debts.
One can relate this to the saying “Money makes money and that money can help you make even more money”.
How to increase your wealth with compound interest- an example
Imagine that you have 1 lac savings in the bank account that earns you around 5% as annual interest. In one year, you would earn Rs. 5000. This will give you a new balance of one lakh and five thousand rupees. In the second year, you would earn another 5% but not on just 1 lac but the latest balance i.e. 1 lac 5 thousand rupees. Now, the interest on this will be 5 thousand and 250 rupees. Hence, you will get a new balance of 1 lac 5 thousand and two fifty rupees.
Over time, this growth would accelerate to multifold. Imagine what would happen if you left this account in the bank for over 20 years or so.
Compound interest Vs. Simple Interest
To thoroughly understand the concept of compound interest, it’s important to know how simple interest is different. SI is calculated on the basis of the principal amount. This earned interest is not calculated or reinvested into the principal when calculating. For instance, if you deposit 1 lac, the interest would apply on the same 1 lac rupees only for coming years. Here, the earned interest is not added in the principal amount as it happened with compound interest.
Simple interest is basically calculated know the charges of loans and other shorter-term loans such as cars.
How to increase your wealth using Compound Interest
Savings Accounts
When you put money into a bank account that gets interest, like a savings account, the interest will be added to your account and the interest amount will go up. In the long run, this helps your balance get better. Savings account interest rates were notoriously low until recently. But as interest rates have gone up, so have the rates on savings accounts.
Retirement Savings Accounts
People often use the retirement system as an example of how compound interest works, and they’re right. The retirement policies or accounts grow over time thanks to the daily crediting rate of their funds. Accounts such as Provident Funds or Roth IRA are kept for a long time, from the first job to the last. This is like decades of magic working together. Many individuals choose to boost this effect even more by putting extra money into their superannuation accounts on top of the amount that their employers are required to put in.
Long-term deposits- FD (Fixed Deposits and Recurring Deposits)
You might be able to use compound interest on your term savings account if you set it upright. For instance, instead of getting a big sum when the term ends, you can get a payment every month. Should you decide to re-invest this monthly payment, you will earn interest on top of the interest you already earned.
Stocks and Mutual Funds
Many investors take advantage of compound interest by not cashing out their monthly or yearly profits or gains on investments. Instead, they put the money back into the fund or market. This can help them get multiple benefits in the long run.
How to make compound interest work for you
Stay patient
Compound interest can help you only if you give it time. Here, patience and intelligence is the key. The sooner you start saving, the longer you give your money, the time to grow. This is why experts say that investing for retirement should start as soon as possible. The earlier you start, the more of your retirement funds will grow.
Make sure you pay down debt quickly
Compound interest is a two-edged sword. To ensure that it does not work against you, you have to pay your loans and debts as aggressively as possible. Be it through student loans, credit cards, money lenders, or other forms of borrowing money; make sure that you make the payments early. The faster you pay these, the less money you will owe over time. This will also ensure that you have a good score and that compound interest is working for you, not against you.
Reinvest in your earnings
The more you reinvest the more money you will have later. Usually, it’s quite tempting to use your savings or investment dividends. But you need to keep reinvesting to get a splurge of wealth in the long run. This key idea is to increase the principal amount on which the interest will be applicable.
Keep checking the compounding rates
The more you research about compounding rates, the better you can plan your strategies. Also, if your account compounds interest more frequently, it will lead to more wealth. By thumb rule, you would want your savings products to compound regularly and your debts to compound as infrequently as possible.
Check out this interesting blog to learn how to gain higher wealth with compounding.
The Takeaway
Compound interest can help elevate your savings and give you the potential to garner good wealth. However, the key here is time and patience. When done successfully, the idea of compounding will help you make money on the money you earn. However, if you stay in debt for longer, things can soon turn awry. Summing it up, compounding is a powerful motivator that can help you pay off your debts and allow you to start investing to earn legit money.
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FAQs
How does compound interest can help increase my wealth?
In its essence, compound interest is calculated on your sum plus accumulated interest over time. This way, a chain of interests adds up and results in increased wealth over time.
How can I start investing with compound interest?
The easiest way is to open long-term deposits in your bank accounts. You can open FDs or RDs for the long term or keep renewing them, year by year, to see your amount grow.
Is compounding legal?
Compounding is a legal way of earning wealth over time. It all depends on the strategies you make and the research you do before investing.
How does my money grow by compounding?
Using compound interest, you get interest on your earned interest along with the original invested money. This increases the money with time.
Does compound interest work in Stocks?
Yes, it does. Your stocks will garner interest over time and you can use it to make more investments and get more returns.