Do you know how compounding interest works? Do you know how it works to your advantage? If not, time to find out.

 

To put it simply, compounding interest means that you earn money on the money you originally invested along with any accrued interest. In other words, it’s the practice of making money on your original deposit along with any interest you’re earned over the period that it’s been invested. It’s sometimes called “interest on interest.” Let’s use a simplified example.

 

In Year 1, you deposit $1,000 in a savings account at 4% interest, compounded annually.

As you can see, you’ve earned $216.64 over a 5-year period. Your money is making money. Now, over the last year, my investments have averaged 7.5% in my various investment accounts. So, lets use the same $1,000 invested over the same 5 years at 7.5% in your retirement fund.

In this scenario, you have earned $435.63 which is $218.99 more than the first example. It absolutely defines how a higher rate of interest makes your money grow faster. It also assumes that you don’t add any more money as the years go on. If you did, your money would grow even faster. Here’s one more example using the same 7.5% but adding an additional $1,000.00 each year.

 

You have invested a total of $5,000 over 5 years. You have earned a return of $1,088. 41 in that same time period.