Do you know how to get the most out of your compound interest? Using a compound interest calculator can help you make the best financial choices and maximize your money.
If you don't understand compound interest and how to make it work for you, you're missing a key piece of your investment strategy. Below, we'll break down what you need to know to get the most out of your compound interest.
When you look at your savings, investments, and compound interest amounts, it can be hard to see what kind of growth you're looking at for the future. That's where a compound interest calculator comes in.
A compound interest calculator shows you how much your money can grow with just the click of a button. This can be helpful for comparing investment choices, planning for retirement, and much more!
Before you can understand compound interest, you need to have a solid grasp on the concept of interest itself.
Interest, in short, is a reward for lending out your money. When a bank lends money for a car loan or a mortgage, for example, they charge interest.
Credit companies also charge interest when you have a debt balance on the card. That's why your credit card bill can quickly rise if you don't pay off your balance each month.
But if you save money in certain accounts, such as bank accounts, you get to collect interest. The money in your accounts is money that the bank or financial institution can use for purposing like loans to other customers.
When you leave money in the account where it can be used, interest is your reward.
Compound interest is how often interest is paid on both the principal and on your earned interest.
With compounding, interest is reinvested, rather than paid out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest.
Let's say you keep $1,000 in an account, with a three percent yearly simple interest payment. You'll get $30 each year as long as the money stays there.
Using the same scenario above, with compound interest you'll get $30 for the first year. The next year, you'll have $1,030 in the account, and your interest payment will be three percent of that new value, or $30.90.
With the above example, you can probably start to see how compounding works.
As your investment grows, compound interest grows with it. The money that you keep invested generates interest earnings, then those earnings also generate more interest earnings.
This means that the longer you keep your money where it is, the bigger it will grow with compound interest.
In the first few years, the growth might be small. But over decades, compound interest can result in huge returns.
You might be wondering just where you can reap these benefits. Let's take a look at some of the places where compound interest can work for you.
Bank accounts are one of the most well-known vehicles for gaining compound interest.
Most savings accounts try to attract savings by offering interest that's higher than the interest for a checking account. In fact, a lot of checking accounts don't pay any interest.
Compound interest also gets earned on money in certificates of deposit (CDs) and money market accounts.
A lot of bonds just pay fixed interest amounts. However, a few types, such as zero coupon bonds, use compounded growth.
With a normal bond, you'll pay the bond's face value, and collect the simple interest payments. Then when the bond reaches maturity, you get the face value of the bond back.
However, a zero coupon bond lets you pay less than the face value initially, then collect the full face value at maturity, with no interest payments in between.
The difference in the amount you pay and the face value you get back is made up with compound interest.
Compounding can even apply to accounts that don't earn any interest at all.
For example, if you have stocks that pay dividends, you can reinvest those dividend payments by using them to buy more shares of stock. Then those shares also grow in value and eventually give back their own dividend payments.
This causes your portfolio to grow even faster, thanks to a type of compounding. You should aim to have compounded growth in your portfolios since this is a great way to maximize your investment.
Compounding is a valuable financial tool. However, if you're strategic, you can make it work even harder for you. Here are a few ways to get the most out of your compound interest.
At first, it's best to focus more on saving than on holding the "right" kinds of investments.
It doesn't really matter if you're investing at all, as long as you're working on growing your savings account. Instead of trying to learn all about investing, just work on adding more to your savings account every month.
Compounding takes a long time to show significant growth. Initially, as you're focused on saving, the money will seem to grow very slowly.
But once you start to save enough money to invest, the returns will quickly grow. Be patient, and keep your money invested. The snowball effect of compounding will grow it for you.
Don't save so much that you feel a financial pinch. Invest in your health and your career growth so you can keep the funds flowing in to save and grow with compound interest.