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  • Writer's pictureDavid Greenfield

How does Compound Interest work?

Updated: Jan 24, 2023

What you will learn in this article:


1. What is compound interest?

Compound interest is a powerful concept that can help you grow your wealth over time. It works by adding interest to your principal, and then calculating interest on the new total. This means that your money has the potential to grow at an exponential rate, rather than a linear one.


Essentially Compound Interest is your money growing on itself!


2. Examples of Compounding in action


Below we'll explore the power of compound interest by looking at examples of how a one-time $10,000 investment can grow over 10, 20, 30, and 40-year time periods, with an interest rate of 8% which is a conservative rate of return for an S & P Index Fund. We'll also add one example of investing $10,000 per year for 30 years at 8% interest.


Example 1: Investing $10,000 for 10 years at 8% interest: If you invest $10,000 for 10 years at an interest rate of 8%, your investment will grow to $25,937.38. This means you will have earned $15,937.38 in interest over the 10-year period.


Example 2: Investing $10,000 for 20 years at 8% interest: If you invest $10,000 for 20 years at an interest rate of 8%, your investment will grow to $48,843.57. This means you will have earned $38,843.57 in interest over the 20-year period.


Example 3: Investing $10,000 for 30 years at 8% interest: If you invest $10,000 for 30 years at an interest rate of 8%, your investment will grow to $104,389.74. This means you will have earned $94,389.74 in interest over the 30-year period.


Example 4: Investing $10,000 for 40 years at 8% interest: If you invest $10,000 for 40 years at an interest rate of 8%, your investment will grow to $221,907.12. This means you will have earned $211,907.12 in interest over the 40-year period.


Now, what happens if instead of investing a lump sum of $10,000 one time, you are investing $10,000 every year:


Example 5: Investing $10,000 per year for 30 years at 8% interest: If you invest $10,000 per year for 30 years at an interest rate of 8%, your total investment will be $300,000, and it will grow to $731,938.27. This means you will have earned $431,938.27 in interest over the 30-year period.


As these examples show, the longer you invest your money, the more it has the potential to grow through compound interest. Additionally, by adding regular contributions to your investment, compound interest can grow your money even more. Keep in mind that these are examples, and the actual interest rate will depend on the financial institution and the investment conditions.


If you want to play with your own numbers, check out a compound interest calculator here:

Conclusion:


In conclusion, compound interest is a powerful tool that can help you grow your wealth over time. By investing a lump sum or regular contributions, and keeping the money invested for a long period, you can take advantage of compound interest and watch your money grow exponentially. It's a great way to achieve financial independence and reach your long-term financial goals.


For a better understanding of the risks of investing in the market check out my article here.

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