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It makes us very happy when we check the balance of our account and see that it has increased without any new deposits, whether it's our savings account or retirement fund. Investment accounts, like retirement accounts, grow more due to the power of compounding when you start saving early through earnings or dividends. In this article, we will show you how compound interest works like fuel to boost your small investments into lump sum money.
The main concept: At its core, compound interest works by reinvesting the interest earned on an initial investment, allowing the investment to grow at an accelerated rate. Over time, this snowball effect can lead to significant wealth accumulation, even with modest contributions.
Let's have a look into three things that play a crucial role while we are creating the value of compound interest.
- Rate of returns: The higher the rate of return(APY) on your investments will be, the higher your money will grow.
- Frequency of Compounding: It is important to consider whether your investment account is compounding your funds annually, quarterly, monthly, or daily.
The span of time: The more time you invest your money in your savings accounts or retirement accounts, the more you will enjoy the benefits of compounding as your money will have more time to compound.
Calculate. Calculating compound growth involves understanding the principles of compound interest and utilizing mathematical formulas or online calculators. The compound interest formula, which takes into account the initial principal, the interest rate, and the time period, is commonly used for this purpose.
The formula for calculating compound interest is: A=P(1+r/n)nt
Where:
- A represents the anticipated value of the investment
- P denotes the principal sum invested
- r is the annual interest rate (in decimal)
- n indicates the frequency of interest compounding per time
- t signifies the duration of the investment period, measured in years.
Let's break down what happens to your money using the power of compounding interest.
After the first year, your $10,000 starts to grow. With monthly compounding, you're earning interest on both the original $10,000 and the accumulated interest. By December 31, 2019, your balance will be more than $10,000 plus 8.5% due to compounding. This process continues every month for four years, as interest is calculated on the updated balance each month, allowing your investment to grow faster.
By January 1, 2024, your initial $10,000 has grown to approximately $15,036. With this example, we can see the magic of compounding at work. The magic of compounding means that a $10,000 investment has grown more than fifty per cent in just five years. This exponential growth is exactly why starting to invest as soon as possible, and allowing your money to grow for such a long period, are crucial.
