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Compounding Interest: What Is It? How Does It Work?

Eve Halimi

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."

Compounding interest is essential for finding success in the stock market.

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.

What is Compound Interest?

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.

How Does Compound Interest Work?

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.

Compound Interest in Action

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:

$10,000 * 0.05 * 5 = $2,500

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:

$10,000[(1 + 0.05)^5 – 1] = $2,762.82

In this case, compound interest results in an additional $262.82 for the same amount of effort!

How Compound Interest Benefits You

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.

Start Compounding Today

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.

Time is the most critical factor when it comes to earning money in the stock market. Investing $100 today can make you hundreds of thousands of dollars richer than someone who invests $1,000 thirty years from now. And with compounding interest, you don't need a large disposable income to invest.

Don't waste more time you could be using to earn compounded interest. With Alinea Invest, it's never been easier to make responsible, smart investments. Download the app today to get started.

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The Content is for informational purposes only, you should not consider any such information or other material as investment, financial, or other advice. Nothing contained on our Site constitutes a solicitation, recommendation, endorsement, or offer by Alinea Invest or any third party service provider to buy or sell any securities or other financial instruments in this or in any other jurisdiction. When investing your capital is at risk.

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