Personal finance can be a complicated topic, and it certainly seems very complicated if you’re trying to figure out the most effective financial moves to make as a total amateur. If you’re unfamiliar with common financial terms, or if you have very limited experience in managing a budget, discussing the nuances of compound interest or retirement investing may seem beyond your grasp.
But the reality is that the most important principles of personal finance are also the simplest and most straightforward. Among these principles is the power of compound interest, which you can manipulate to work in your favor.
So what exactly is compound interest and how can it work for you?
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What Is Compound Interest?
Compound interest is a term for interest that builds upon itself over time. Let’s imagine that you have $1,000 invested in a savings account that generates a miraculous 5 percent rate of interest annually. Assuming you don’t add anything to your account, at the end of your first year, you’ll make $50 of interest. But what happens the second year? Your principal is now $1,050, so you’ll make 5 percent on that – meaning you’ll make $52.50 instead of just $50.
That may not seem like a big difference, but keep in mind that this continually compounds, adding more interest with each iteration. After 14 years of compounding, you’ll nearly double your money, despite adding nothing to your account. After 22 years, you’ll nearly triple it.
Using a compound interest calculator, and tinkering around with the variables, you can see just how big of a difference even the smallest financial moves make on a large scale. If you commit to investing just a few hundred dollars a month over the course of decades, compound interest could eventually make you a millionaire.
Of course, there’s a negative side to this equation as well; compound interest can work against you if you’re not careful. Just as compound interest can build up your principal in an investment, it can increase the total debt you owe to a bank or credit card company.
How to Use Compound Interest in Your Favor
So what are the best ways to make compound interest work for you?
1. Seek lower interest rates for your debts.
Even if you avoid using credit cards entirely, there will be other times in your life when you almost need to take on debt. For example, if you’re purchasing a house or adding a rental property to your portfolio, you’ll almost certainly need to take out a mortgage to cover the cost of the property. Whenever you take on new debt, try to seek the lowest interest rate you can. If mortgage rates are high, wait until they’re lower. If your credit card interest rate is high, negotiate for a lower one or shop around for a better credit card. As we’ve established, even very small changes to an interest rate can lead to a drastic difference over time.
2. Pay down your debts faster.
In line with this, it’s important to pay down your debts as quickly as possible, especially if they’re associated with high interest rates. Making minimum payments can help you avoid damage to your credit score, but it’s usually better to exceed these payments so you can eliminate your debts and avoid the negative power of compounding. Consider picking up an extra job or making strategic cuts to your budget to make this happen.
3. Start investing as early as possible.
The best time to start investing is the moment you get the opportunity, possibly many years or decades ago. The second-best time to start investing is today. The sooner you start investing, the more time your investment will have to grow, utilizing the power of compounding to eventually grow larger. Ideally, you’ll start investing many decades before you retire.
4. Choose investments wisely.
Some investments are strictly better than others for generating compound interest. Look for investments with low risks, reasonable amounts of stability, and somewhat predictable returns, like rental property investments, dividend stocks, and high yield bonds.
5. Reinvest your earnings.
When you generate income from your investments, always reinvest your earnings. This will allow your investments to accumulate and grow faster.
6. Avoid touching your principal.
Similarly, it’s important to avoid touching your principal. Certain retirement accounts allow you to make early withdrawals under certain circumstances, and if you’re investing in a conventional brokerage account, you can pull your money out at any time. However, if you want to fully capitalize on the power of compound interest, you should leave your principal untouched for as long as you can.
7. Delay your retirement (if possible).
Delaying your retirement may seem like a step backward or a strictly negative strategic move. After all, many of us dream of retiring early. But delaying your retirement for even just a few years can buy you more time to rack up compound interest and add to your principal.
If you can capitalize on the power of compound interest, you’ll take total charge of your personal finances. You’ll eliminate the control that debt has over your life. You’ll earn more from your investments. And if you start young enough, you could end up retiring very wealthy, even if you only make a modest amount of money.