7 Simple Calculations that Show the Awesome Power of Compound Interest –

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How Compound Interest Could Impact Teens and Their Savings

Your teenage years are a good time to start saving money for the future. Because you have time for that money to grow before you may need it to buy a house or retire, you can benefit greatly from compound interest. One easy way to start earning compound interest is to open a high-yield savings account and contribute a set amount to it every month. Over time. your money could grow a lot and allow you to build your wealth. While you may only be able to earn a small amount of interest in a savings account, the compound interest could add up over time. For example, if you contributed $50 per month to a high-yield savings account and earned 0.5% interest per year, you could have over $12,000 after 20 years.

Once you've got the savings part down, you could try your hand at investing to potentially benefit even more compound interest. For example, let's say you opened an investment account with the help of an adult (you usually need to be 18 years or older to invest). If you contributed $100 per month to the investment account for 40 years, and earned a 10% annual rate of return on investment each year, your money could grow to be more than $530,000.

The data doesnt lie

Michael saved $1,000 per month from the time he turned 25 until he turned 35. Then he stopped saving but left his money in his investment account where it continued to accrue at a 7% rate until he retired at age 65.

Jennifer held off and didn’t start saving until age 35. She put away $1,000 per month from her 35th birthday until she turned 45. Like Michael, she left the balance in her investment account, where it continued to accrue at a rate of 7% until age 65.

Sam didn’t get around to investing until age 45. Still, he invested $1,000 per month for 10 years, halting his savings at age 55. Then he also left his money to accrue at a 7% rate until his 65th birthday.

Michael, Jennifer, and Sam each saved the same amount — $120,000 — over a 10 year period.

Sadly for Jennifer, and even more so for Sam, their ending balances were dramatically different.

SaverEnding Balance
Michael$1,444,969
Jennifer$734,549
Sam$373,407

What Is a Simple Definition of Compound Interest?

Compound interest refers to the phenomenon whereby the interest associated with a bank account, loan, or investment increases exponentially—rather than linearly—over time. The key to understanding the concept is the word “compound.”

Suppose you make a $100 investment in a business that pays you a 10% dividend every year. You have the choice of either pocketing those dividend payments like cash or reinvesting those payments into additional shares. If you choose the second option, reinvesting the dividends and compounding them together with your initial $100 investment, then the returns you generate will start to grow over time.

Power of Compounding and mutual funds

We have talked about the benefits of investing a fixed amount regularly to benefit from compound interest. But there is a big question to be addressed. Where can an investor put his money to achieve the full benefit of compounding? 

The answer is mutual funds

As an investment avenue, mutual funds are designed in a way to magnify the benefits of compounding. This is possible through Systematic Investment Plans (SIPs)

Here’s how it works: You can invest a fixed sum in mutual funds regularly through a Systematic Investment Plan (SIP). This can be monthly, quarterly or semi-annually. You can select the fund of your choice, use an SIP calculator to calculate the return on your investment and make a SIP payment on the allotted date. Investing regularly through SIPs could  magnify your returns over time. 

While you can invest in most fund types through a SIP, you may want to consider investing in equity funds for long-term goals like retirement planning. This is because equity funds have the potential to offer better returns in the long-term. 

The best part about SIPs is that you can automate your payments by giving a standing instruction to your bank. You can transfer money from your registered bank account directly to the mutual fund on the specified date. As a result, you don’t need to worry about missing payment schedules.

Compound Interest Investments

An investor who opts for a dividend reinvestment plan (DRIP) within a brokerage account is essentially using the power of compounding in whatever they invest.

Investors can also experience compounding interest with the purchase of a zero-coupon bond. Traditional bond issues provide investors with periodic interest payments based on the original terms of the bond issue, and because these are paid out to the investor in the form of a check, interest does not compound. Zero-coupon bonds do not send interest checks to investors; instead, this type of bond is purchased at a discount to its original value and grows over time. Zero-coupon bond issuers use the power of compounding to increase the value of the bond so it reaches its full price at maturity.

Compounding can also work for you when making loan repayments. Making half your mortgage payment twice a month, for example, rather than making the full payment once a month, will end up cutting down your amortization period and saving you a substantial amount of interest.

What is compound interest?

Compound interest is when you earn interest on top of the interest you've already earned on the principal amount of money. For example, if you started with $100 and earned 10% interest in one year, you'd have $110 after one year. If you earned 10% on that $110 over the course of another year, you'd end up with $121. Compound interest is the money you earned in that second year because the interest applied to your original principal and the interest you earned in the first year.

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