Introduction
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We’ve all heard of the Seven Wonders of the Ancient World; feats of remarkable construction built throughout our history. Compound interest is referred to as the world’s eighth wonder in a phrase attributed to Albert Einstein.
You may not be aware of how he concluded that quote. The saying goes, “but he who understands it, earns it, and he who does not… pays it.”
In this post, we’ll be talking about compound interest and why Einstein thought it should be considered the 8th wonder of the world.
- What is it? How does it work? And why should we care? Let’s find out!.
What is Compound Interest?
What Is Compound Interest? Interest on the principal amount plus any interest already earned is compound interest. What? Yeah, most of us are in the same boat… a little bit lost! We need to simplify things! The compound interest is only interest at the top of interest interest.
It is important to remember that the principal is equal to the total amount of lending or investment, and interest is calculated as a percentage of the principal.
For compound interest to operate, interest is calculated on the total amount, including the interest already earned. It can be calculated using a simple formula.
This is fantastic for mathematicians, but a practical example would be more helpful than theoretical ones for the rest of us. You deposit $100 into a savings account.
The interest rate on this account is 1% per year. That means there was a $1 profit at the end of the first year of compound interest.
You now have $101. In year two, you’d earn 1% on $101 which would be $1.01. At the end of year two, you will have $102.01 (your initial $101 and your additional interest of $1.01).
In two years, you’ve made a grand total of $2.01. It may not look like a significant deal, but we used a modest amount for clarity’s sake.
If you turned that $100 into 1 million dollars, then 1% is $10,000! It’s hard to deny the power of compound interest. It becomes a really big deal when using more considerable sums over longer periods of time.
You can always play around with compound interest number by using calculators available online to get an understanding of how powerful it is. Compound interest can be used to your advantage, so let’s find out how!.
Saving
1. Saving Compound interest’s magic is limited with money in a bank or savings account. Why? In general, the interest rates on savings and checking accounts are so low that they have minimal impact.
Savings accounts typically get only 1% percent interest, and the checks of accounts only pay either 0.05 percent. In general, it is okay to leave enough money in your checking account to cover two months of expenses, and outside the emergency fund, you should not give up a large amount of cash in low-upper accounts.
But if you are hesitant to start investing, then there is nothing wrong in keeping your money in your checking and savings accounts unless you create your risk tolerance or decide on the suitable investment path for you.
Investing
2. Investing because we are working with a more important amount in the more extended period, compound interest actually comes into the game in terms of investment.
- You should begin investing early and frequently to reap the investment’s full benefits. Time and regular contributions equal wealth when it comes to compounding interest!.
Retirement Investing
- 3. Retirement Investing Taxes are levied on any gains or distributions made in a non-tax-advantaged account. Distributions are taxed the year they are paid out.
Still, appreciation isn’t taxed until an investment is sold for a profit. As a result, tax-deferred retirement funds should be included in every investor’s portfolio because the tax rate and timing of taxes play a role in compounding interest returns.
Investments in 401ks and IRAs can be tax-deferred, so the money in the account grows tax-free. You won’t owe taxes on the funds until you take them out to cover expenditures once you’ve reached retirement age.
It’s common for folks to have lower tax brackets when they’re retired compared to when they worked (because you’d technically be earning less money). Since you don’t have to pay taxes on your money’s growth for years, time becomes your friend.
With a constant yearly interest rate, it’s easy to calculate how long an investment will take to double. “The Rule of 72” is what it’s called.
- With 7 percent annual stock market returns, the 72 rules say that it will take us about 10 years to double our initial investment.
- Therefore, after ten years, an investment of $ 1,000 in your 401K would have increased to $ 2,000 if you don’t touch it.
When It’s Bad!
Worst Case Scenario… When It’s Bad… What makes compound interest so wonderful when it’s working in your favor? You’re earning interest on the interest you’ve accrued.
Compound interest works against you in the same way. Interest on interest increases your debt obligations. Even a single day’s delay in making regular interest payments can harm your interest rate.
The magnitude of your payments could add up to a significant sum of money. If compound interest is working against you, it’s dreadful. Most people feel the negative effects of compound interest in credit card and student load debt.
If you only pay the minimum due on your debt, most often, you’re only paying the interest, but remember, interest compounds, so it continues to add onto your overall debt unless you can prioritize paying interest and a portion of the principal amount each month.
You must do everything in your power to make compound interest your friend rather than your enemy. Don’t give up hope. It is possible to prevent becoming a victim of compound interest.
- 1. Improve Your Credit Score If you have a good credit score, you’ll get.
Improve Credit Score
- a lower interest rate on loans for things like a house, a car, or a small business..
Pay off High Interest Debt
2. Pay Off High-Interest Debt In the long run, it makes little difference what your APR is if you pay off your credit cards each month in total.
You may pay more interest than the original amount you borrowed if you keep your balances high for a long time. Remember, most of your minimum monthly payment is spent on interest rather than the original principal debt.
- If you have credit card debt, you need to take action sooner rather than later because the interest rate is compounding at an alarming rate.
The same goes for student loans. It may make sense to take a look at your loans and try to consolidate to help ease the burden of compounding interest.
Conclusion
There’s a lot of power in compound interest. When used correctly, it can help you become wealthy. For years, if not for the rest of your life, it can keep you broke and poor if you misuse it.
Allow compounding interest to work for you by investing it rather than owing it. It brings us to the end of our post. If you have learned something new today, share this post with your friends.
