Albert Einstein called it "the greatest mathematical discovery
of all time."
For those who carry hefty debt on their monthly
bill, Einstein's law of financial physics is not good news. But for
the savvy investor, the principles of compound interest can be used
to make a substantial amount of money over time.
To tap into the money-making magic of compound interest, it's
crucial to first understand what compound interest is and how it
is the exponential increase of an investment. But in simpler terms,
compounding is interest you earn on interest.
For example, let's say you put $2,000 in the bank. If interest is
paid 5% annually, the bank will give you about $100 in interest for
the first year of your investment. If you leave that $100 in your
account, it will start earning interest, too. The following year,
balance will earn $105 in interest. Over time, this phenomenon
turns into the powerful magic of compound interest.
Here are some important ways to make compound interest work to your
Use the power of time: Compound interest is most powerful over a
long period of time. Looking at the above example, your $2,000
initial investment would double in about 14 years. If all the money
remained untouched, it would earn twice as much interest between
years 15 through 28. In year 29, you'd effectively be earning 20%
interest on the original investment (sometimes called "
yield on cost
"), all without needing to lift a finger.
See for yourself:
The earlier you start, the better: Whether you're in your mid-30s
or mid-60s, it's never too late to start saving. If you can afford
to put away even $100 a month, starting now, compound interest will
duly reward you -- even in today's low interest-rate environment.
For example, at age 33, a $100 per month ($1,200 annual)
contribution at a 1.5% annual interest will turn into nearly
$60,000 by age 70. If you start at age 66, then this same
investment amounts to just $5,000. Still, not bad. But, it clearly
demonstrates that the longer you can let your investment sit and
earn interest, the better.
Maximize your "compounding periods": The more frequently interest
is paid, the more quickly wealth will build. Interest that
compounds monthly will grow faster than interest that compounds
quarterly or yearly. Therefore, to quickly obtain wealth, always
chose the shortest compounding period you can.
Earn interest, don't pay it: Compound interest can work the other
way, too. A typical credit card company charges 20% monthly
interest on unpaid balances. Factoring in 20% compound interest, an
unpaid credit card balance of $1,000 at the beginning of the year
will turn into more than $1,200 in debt by the end of the year. To
, inversely apply the principles of compound interest. If you can,
then transfer your credit card debt to a lower interest plan, and
chose loans with a yearly, rather than monthly or quarterly
Taking these principles into account, there are many investment
vehicles built to compound. All can help maximize your
Here are some top contenders to consider:
1. High-interest savings accounts
In this low-interest environment, it's hard to find banks
attractive rates. However, with enough digging, some decent rates
can be found. Currently, 1.08% seems to be the top interest rate in
the United States, while 2.1% is the best rate we've found in
If you're looking to invest now, then you may want to pay
particular attention to websites that update bank interest rate
information on a daily basis. Even a few percentage points can make
a difference. For example, a $5,000 investment that earns 0.8%
compound interest for 5 years can turn into $5,200. This same
investment at a 2% compound interest rate will turn into about
$5,500. For the extra $300, it's probably worth the 30 minutes it
may take to find the better rate. Bankaholic is particularly good
for U.S. consumers, while High Interest Savings is a good one for
It's also nice to know that, although banks may list going rates on
their websites, many are willing to negotiate. Before agreeing to a
set rate -- whether it be for a high-interest
, a loan or even a car payment -- ask whether the provider
has "any discretion." You may get a somewhat baffled look,
but, by just asking, the lender is likely to give you the most
advantageous rate available.
2. Certificates of deposit (
)/guaranteed investment certificates (GICs)
These are secure investment vehicles (CDs in the United States,
GICs in Canada) that
a fixed interest rate until a specific
. The advantage of this investment tool over a high-interest
savings account is it offers a guaranteed interest rate that will
remain unchanged for the term of your investment. The catch is your
money is not
. You must keep it locked up for the specified time period.
often results in a penalty. The interest gain is generally taxable.
There are different types of CDs and GICs, each with its own terms,
advantages and disadvantages. Currently, CD and
interest rates are about on
with high-interest savings account rates. As such, for the average
investor, it is currently likely no more advantageous than a more
liquid high-interest savings account.
Stocks that pay dividends can be a great way to bring in extra
income. To realize the power of investing dividend payments, check
out the story of Grace Groner:
After graduating from Lake Forest College in 1931, Grace was hired
as a secretary at
Abbott Laboratories (
, where she worked for more than four decades.
Grace never earned an amazing salary as a secretary. According to
the Los Angeles Times, she got her clothes from garage sales. She
lived in a one-bedroom house that was willed to her when a friend
But in 1935, a few years after she started her job at Abbott Labs,
she bought three
of the company's stock for about $60 each. Her total investment was
Grace never sold those shares. Through dividends, share splits, and
dividend reinvestment, when she died in 2010, her three-share
purchase was worth $7 million. She left it all to her alma mater.
The two most important lessons from this story?
A) She started with $200.
B) She took advantage of the power of compounding -- for 75 years!
Action to Take -- >
By understanding how to maximize the power of compound interest,
you too can build substantial wealth over time. The important thing
to remember is, no matter what shape your finances are in right
now, you can change your financial future by taking advantage of
You can find a range of free financial calculators to help you
maximize your savings
, or try
this compound-savings calculator
to see how much you should set aside each year to reach your
-- Dr. Melvin Pasternak
Melvin Pasternak does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC owns
shares of ABT in one or more if its "real money" portfolios.
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