What Is Compound Interest?

Compound interest has been named the 8th wonder of the world.

And for good reason.

It’s not a monument. It’s not a statue. It’s nothing tangible.

But those who understand it, earn it.

Those who don’t, pay for it.

So what is compound interest?

It’s the principle by which the interest you earn also earns interest, and the interest on that interest also earns interest.

The ceiling of how much you can earn extends forever and the larger your balance gets (your nest egg), the bigger those interest numbers become.

All thanks to what’s called exponential growth.

How Does Compound Interest Work?

Compounding is popular among investors because it’s a great tool for forecasting the future value of your wealth.

The “interest on interest” effect can generate some large sums but ONLY IF you give it the time and patience it needs to grow.

Since compounding is helpful for figuring out how much and how long you need to save, we can use it to create a plan for our financial goals.

An Example Of Compounding

Let’s take two different scenarios and compare how compound interest affects each person with different time horizons.

How To Take Advantage of Compound Interest

Starting Early
The best time to start was when you were born. The second best time to start is today.

We hear this all the time, because it’s true. Time is your greatest ally when it comes to taking advantage of compound interest.

Even small contributions can grow into large sums if you give it enough time to do so.

A small $500 investment today could turn into $8,724 in 30 years at a 10% average return per year.

Imagine what you could do with $5,000 or $50,000.

Contribute Regularly
Consistent contributions are the key to fueling the compounding effect.

It’s great to have money sitting there accumulating interest for you in the background without touching it.

But things start to get really fun when you continue contributing to that amount with your own money.

Every time you contribute some more dollars, those dollars start working for you and accumulating interest.

When new money is flowing into the account earning interest, as well as the existing money earning interest, that’s when the snowball starts growing even faster.

Reinvesting
This goes without saying, but I’ll say it anyways.

If you really want to take advantage of the compounding effect, you have to understand what fuels it.

The answer: reinvesting.

You might be tempted to pull out that $100 dividend and use it for yourself.

DON’T.

Keep it inside the money pit.

The money pit is your nest egg, and any dollars that get removed from that is another dollar not working for you.

As the saying goes, “it’s not about how much you make, but how much you can keep”.

Plenty of people make a lot of money every year, but they’re unable to hold onto enough of it to see the compounding effect in full force.

Minimize Fees and Taxes
A common issue among new investors in particular is the ignorance of fees and taxes.

Remember, you want to keep as much money as you can.

Some brokerages have hidden fees you need to be aware of, such as trading fees, management fees, account minimums and many more.

Also, over the course of your lifetime, taxes will likely be one of your largest expenses.

Which is why you should be actively working to minimize them as much as you can.

Take advantage of tax-sheltered accounts. These will vary depending on where you live but there are plenty of contribution-limited accounts out there you can use to build your wealth 100% tax-free.

The more you keep, the more you have working for you.

Patience is Key
In the early stages of investing, you won’t notice the compounding effect much at all. In fact, you’ll be so discouraged by how much you’re making you may not even think it’s worth doing.

A 5% return on $1,000 is $50 (not great)

But a 5% return on $100,000 is $5,000 (more than the average monthly income in the U.S.)

The trick is to scratch and claw until you have your first $100,000 invested.

This doesn’t mean you can take your foot off the gas when you get there, but things start to get more fun once you reach that point.

$100,000 is 25% of $1 million.

If you don’t understand why, that’s because you don’t know how powerful the compounding effect is.

See you in the next one!

Alex (The Dividend Dominator)
Founder and CEO of Dividend Domination Inc.
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