How does compound interest work?

You would think that in order to accumulate a lot of money, whether in a savings account, a retirement savings plan or a brokerage account, you would have to constantly put a lot of money aside. But if you save and invest your money wisely over a long period of time, you might be pleasantly surprised at the level of wealth you achieve.

If the idea of ​​watching your money grow before your eyes sounds appealing to you, it’s worth tapping into the power of interest and compound returns.

Here, we’ll go over what compound growth entails and show you how a series of relatively small contributions to a savings or investment account can grow into a substantial sum over time.

How does compound interest work?

At its core, membership is the concept of earning interest over interest.

Imagine putting an initial deposit of $ 1,000 into a savings account that earns 2% interest. This means that after one year your balance will drop to $ 1,020 without adding any additional money.

Now here’s the cool part: if you keep that money where it is, you will continue to earn interest not only on the initial $ 1,000 you invested, but also on that $ 20. Assuming your interest rate stays the same, you will earn $ 20.40 in interest in your second year of having that money in this account, for a balance of $ 1,040.40.

After 40 years in this account, earning the same interest, your $ 1,000 will increase to $ 2,208.04, more than double your initial savings, with no investment or additional work.

Typically, you don’t just save some money and get back to it 40 years from now. In fact, most people save or invest weekly or monthly. So your savings grow with your principal – the money you invest in them – plus interest which continues to accumulate as the initial balance increases along with both principal and interest.

What are the advantages of compound interest?

The advantage of the composition? It can make your money grow. Interest means you earn money without having to do any extra work. Then the money you earned keeps earning even more – it’s made worse. Your money keeps growing whether you keep adding it or not.

The downside: if you are accused compound interest – say, on a credit card balance – your debt can go up just as easily.

How does compound interest work on the stock market?

Imagine that you are looking to invest your money for a long term goal, like retirement, and you put $ 100 per month in a brokerage or IRA account instead of a bank account. A high yield savings account may only pay 2% interest.

In contrast, investing in the stock market has historically generated an average annual return of 10%, although a return in any given year fluctuates quite a bit. To be on the safe side, we’ll use a 7% return for our calculations.

The following table shows how much money you could end up with, depending on how many years you keep saving: