What Is Compound Interest?

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Grow your investments exponentially

Albert Einstein famously called compound interest the “eighth wonder of the world,” and we’d agree. Move over Great Pyramid of Giza, the spotlight is on a new wonder, and it gets even greater with time.

Compounding is simply the idea that your investments have the opportunity to grow exponentially over time. Not only does your initial investment generate returns, but your past returns also generate returns. Over time, this can have a snowball effect (in a good way) in terms of creating wealth, making it a powerful tool for savers and investors.

How compounding interest works

As a simple example, imagine that you begin with $1,000 in an investment that returns 10% per year. After the first year, your investment will have grown 10% and be worth $1,100. In the second year, not only will your initial $1,000 return 10%, but last year’s gain of $100 will also grow by 10%. By itself, the initial $1,000 would have generated $100 each year, for a total of $1,200. However, because your past gains also benefited, your portfolio is actually worth $1,210. While that extra $10 may seem small, this process could continue and eventually add up to a large amount.

Thus, how much you benefit from compounding depends on a few factors: how much you start with, the rate of return, how often compounding occurs (monthly, annually, etc.), and your time horizon. The higher any of these are, the greater the potential effects of compounding. It’s also important to point out that small differences can have a big impact on your outcomes.

Don’t touch your gains — let them grow

An important idea throughout this discussion is that you should try to reinvest your investment gains. Any gains that are sold or withdrawn won’t benefit from compounding. This is why staying invested over time and reinvesting gains are so important for building wealth. In addition to allowing your investment gains to work for you, reinvesting dividends or any interest payments you earn can help to make compounding work even harder.

This is also how a retirement savings account takes advantage of compounding– you will likely contribute often, benefit from the returns of a diversified portfolio, and have decades over which to invest. Allowing your portfolio to benefit from compounding will greatly boost your ability to achieve your financial goals.

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