Compound Interest: A Powerful Concept That Can Make You Wealthy

by Sean Donohue

Compound interest is a powerful concept which can make you very wealthy if you use it to your advantage. So what is compound interest? When you have money in any interest bearing account, such as a savings account, CD, or mutual fund, that money earns "interest"--which essentially is additional money that the bank or mutual fund company pays you for the privilege of using your money. In the case of a bank, they use your money to make loans to others. Mutual fund companies use your money to buy stocks, bonds, and other financial instruments.

You can choose to have that "interest" re-invested, which simply means that it stays in the account rather than being paid to you in cash. Now the amount of money in your account consists of money that you put in AND interest money put in by the financial institution. The next time your account earns interest, it will be higher (even if the interest rate remains the same) because there is more money in the account. This process is called compounding--which leads to the term compound interest. Investopedia.com defines compounding as follows: "The ability of an asset to generate earnings that are then reinvested and generate their own earnings."

Okay, so what is the big deal? Well, over time, this compounding of interest can have a very powerful effect. Consider this: At 10% interest for 30 years, $10,000 would grow to to nearly $175,000 without you ever adding any more money of your own. Compound interest is truly a big deal!

This next example is even more eye opening....

Suppose you were offered a job with the following pay package: You would earn a penny for the first day of work and it would be doubled for each consecutive day. At the beginning of the next month, the process would start again. For example, the first day you would make one cent, the next day you would make two cents, and so on. Would you take the job? Without thinking about it, most people would say, "No way!" Well, what would you have made if you took the job? On the 30th day of the month alone, you would have made over $5 million! And your total compensation for the entire month would have been over $10 million! Don't believe us? Check out the calculations here.

Grasping the power of compound interest can bring you financial success. A commitment to regular investing, I recommend monthly, will pay huge dividends for you when you reach retirement age! The earlier you start your retirement investing plan, the better your results will be. I recommend putting 10% of your monthly take home pay into long-term investments, such as a Roth IRA or the Thrift Savings Plan, each and every month.

Don't think you have the money to invest every month? Check out the budgeting page and find out how you can free up some cash to invest.

Don't know how to invest your money? Looking for some free investing tips? Check out the investing page for answers to your investing questions.

What is the bottom line? Harness the power of compound interest today and put yourself on the path to amassing a sizeable retirement nest egg!

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