It is well known that investing is one of the most important ways to build wealth in the long-term. But as an investor, do you know that compound interest is one of your best friends in your journey to building wealth?
If you have never heard of compound interest or don’t know what this is, put simply, compound interest is interest earned on the principal amount invested as well as the interest accrued. Compounding interest makes your money work for you, because in addition to earning returns on the money you invest, you also earn returns on those returns at the end of every compounding period.
Compound interest makes a sum of money grow at a faster rate than simple interest. You can compound interest on different frequency schedules such as monthly or annually depending on your investment type. The interest-on-interest effect can create continually increasing returns based on your initial investment amount. This is also referred to as “the miracle of compound interest.”
For example, if you earn 5% annual interest on an investment of $100 you would gain you $5 after a year. What happens the following year is where compounding comes in. After a year, you’ll earn interest on your initial deposit ($100), and you’ll earn interest on the interest you just earned ($5). This means that the interest your money earns in the second year will be more than the year before, because your account balance is now $105, not $100. Put simply, your investment grew through compound interest.
How do you take advantage of compounding interest you ask? There are three ways to do this:
Start investing — It goes without saying that if you do not invest there is nothing to gain returns on. To enjoy compounding interest, start investing sooner rather than later.
Give your investment time — In other words, leave your investment untouched for as long as you possibly can. By leaving your investment untouched, your portfolio gains are reinvested thereby allowing interest accrue on both your principal and reinvested gains.
Invest often — While you can invest and gain compound interest without topping up your initial investment amount, the higher your investment amount is the higher your investment return. As such, it is important to invest often because over time, it can seriously add up.
It is worth noting that compounding interest can also help mitigate wealth-eroding factors such as rising cost of living, inflation and reduction of purchasing power.
In summary, investing often puts the power of compound interest in your favour by putting your money to work — so you don’t have to!