Yep, according to Einstein, compound interest is right up there with the Great Wall of China and the Colosseum in Rome. That being said, it’s probably not a bad idea to learn a thing or two about it.
Let’s start with what it is.
Compound interest is defined as interest calculated on the initial principal and also on the accumulated interest of previous periods.
So basically “interest on interest”. You get interest on the amount of money you put in initially and then interest on any interest that you’ve earned on that. It’s almost like your money is working for you. A truly beautiful cycle.
This is pretty different from simple interest, which is only calculated based on the initial principal amount so it’s unable to gain that fast-growing, snowball momentum that makes compound interest so lucrative.
The key to compound interest.
If compound interest is the key to wealth creation, then what is the key to compound interest?
According to some people who know what they’re talking about (such as Ron Lieber, columnist for Your Money at the New York Times), the key to compound interest is time. The fact of the matter is when you start saving often outweighs how much you save.
This chart changed my life. pic.twitter.com/N3xX6Bhcn4
— (((Ron Lieber))) (@ronlieber) May 18, 2017
So it’s never too early to get started. As in you should start now. Right now.
How to get started.
First of all, you want a savings account. Savings accounts tend to offer higher rates than checking accounts so look towards those to get the money snowballing. Look into the interest rates offered by several different banks, and be aware that it may also be called the APY (annual percentage yield). You can also earn compound interest in certificates of deposits and money market accounts.
The average bond works like this: you pay a lump sum amount upfront to a bond issuer and the issuer then pays you interest on a regular basis (i.e. every six months) plus pays you back your original investment when the bond matures at a predetermined date. But if you’re looking for a compounding interest bond, look no further than a zero coupon bond. The downside of zero coupon bonds is that they don’t pay you any interest in the meantime leading up to maturity. But the upside is substantial: you buy the bond for less money than you will receive at maturity and the amount at maturity reflects compound interest earned. There’s a whole formula for this but we won’t get into that here.
Compounding doesn’t always have to go with interest. It can also be found in the investment realm. If you have stock in a company and use your dividends from that stock to reinvest into more stock, then those shares will grow as well and begin to churn out their own dividends. Another cycle, but this one requiring a bit more work but also a bit more return.