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Power of Compound Interest

I hope by now you’ve realized that you need to consistently invest as much as possible based on your circumstances.

Another reason your wealth will grow faster with consistent contributions is the magic of compound interest. The idea of compound interest goes back to Albert Einstein who famously said: “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t…pays it.”

Compound interest, which is commonly used in finance and economics, occurs when you pay or receive an interest on the sum of principal and interest amounts, not just the initial principal. Simple interest is when the interest is not added to the principal when it gets calculated.

The ultimate result of compounding depends on the compounding frequency (e.g. monthly, quarterly, annually). For any given interest rate and compounding frequency, an equivalent rate for any different compounding frequency exists.

For example, the yearly rate for a loan with 1 percent compound interest per month is approximately 12.68 percent per annum as opposed to 12 percent if it were simple interest. This equivalent yearly rate is often referred to as annual percentage rate (APR).

Compound interest is your friend when you receive it and your enemy when you have to pay it because it grows exponentially. If you currently have or ever had a student loan, a credit card debt or a mortgage on a house, you’ve paid compound interest.

As it may pertain to your particular investment accounts, always re-invest your accrued interest into additional shares so that compound interest will help grow your investment portfolio. If you use brokerage services like Ameritrade, E-trade or Fidelity Investments, they have an automatic reinvestment option that you can set up online for your brokerage account.

Read more on this subject next week…

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