If you're a beginning investor, figuring out the best strategy can be a major challenge. As you research and acquire more stocks, you'll likely come across the term "compounding interest."
But what does it really mean? Read on to learn more about compound interest, and find out how it can help you make money today.
Compound (or compounding) interest is a form of interest that is calculated using the principal investment and the interest accumulated in previous periods. In layman's terms, compound interest is interest earned on interest. As opposed to simple interest (which is calculated using the principal investment only), compound interest will cause your investment to grow at a much faster rate.
To calculate compound interest, first take your annual interest rate and raise it to the number of compound periods, minus one. Add one to this raised number, and multiply it by your principal investment. From here, subtract the initial amount of your loan or deposit. As a formula, compound interest looks like this: [P (1 + i)n] – P.
Interest can be compounded in numerous frequencies, including daily, monthly and yearly. With compounded interest, the more compounding periods you have, the more interest you'll earn. In this way, compound interest is akin to a snowball effect. The more your interest is compounded, the more interest you'll have to compound with.
The magic of compound interest is clear when compared to simple interest profits.
For example, if you invest $10,000 for 5 years at a simple interest rate of 5%, your interest earnings will look like this:
If you were to invest the same $10,000 for the same amount of time at a 5% compounded interest rate, your earnings would instead look like this:
In this case, compound interest results in an additional $262.82 for the same amount of effort!
As a beginner investor, you have the advantage when it comes to compound interest. This is because younger investors have more time to work with in the stock market, even if they start off with a smaller investment.
With compound interest, you'll earn money at every compounding period. The bigger your investment gets, the more money you'll add to your sum each period, causing your return to increase significantly in a relatively short amount of time. This is a key factor in wealth-building, it doesn't require a major investment to reach your financial goals. With compound interest, you can make money investing at any age.
The younger you are, the more time you'll have to earn compounded interest in the stock market. And while it may seem like you have all the time in the world, investing early can make a million-dollar difference.
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