Now that you’re interested in personal finance, you’ve probably heard people tout the benefits of compounded interest over and over again. But has anyone ever explained to you what it means? What makes the concept of compounded interest so attractive to investors and financial planners?
Compounded interest simply means that over time you earn interest on the interest you’ve already earned. Let me explain how this works. Let’s say that you have put $1,000 into a savings account that earns 10% each year. Okay, I know that interest rate is probably a little high, but for this example, easy math works best. At the end of the first year, you will have earned $100 and have a balance of $1,100 in your account. At the end of the second year, you will have earned 10% of the new balance or $110. Now your balance will be $1,210. See, because you left your interest earned during the first year in the account to earn more interest you were able to increase the amount of interest you earned in the second year by $10.
Now that you understand what compounded interest is, it should be easy for you to see how beneficial time is to helping your savings account grow. With each passing year your account will gain in earning power without your ever having to add any money to it. It will grow perpetually all on its own. How cool is that?
That doesn’t mean, however, that you shouldn’t keep adding to your savings account. As much as allowing the earned interest to compound will help your account grow, nothing is quite as effective as making regular deposits to the account. By pairing regular deposits with the time value of money your account will be growing leaps and bounds in no time.
The power of compounded interest is key to planning any type of long-term service savings plan or retirement savings plan. That’s why you hear so many suggestions to start planning for your retirement at a young age. By starting early, you will only have to make small regular deposits to be prepared to retire in style at the end of your career.
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