Compound Interest: The Miracle Behind Wealth Building

imagesAn important feature of investment returns is something called “compound interest”.  With compound interest you can turn a modest middle-class investment account into millionaire status by the time you retire.

So how does compound interest work?

With compound interest, not only your initial investment appreciates in value over time, so does all the gains on that initial investment.  For example, you might expect $100.00 that gains a 10% annual rate of the stock market to appreciate to $110.00 after one year and $120.00 after two years without compound interest.  But if no money is taken out, then in the second year it is not just the initial investment ($100.00) that grows at 10%, but also the gains on that initial investment from the first year ($10.00).  So, after two years the investment is actually worth $121.00. After many years of compounded interest, the gains on the initial investment become very significant, making more money year over year.

The really cool thing about compound interest is how it can double the account value after years of saving.  It’s really like a snow-ball effect; it keeps growing, doubling and doubling over time.  Investment professionals refer to the “rule of 72”, which is basic rule of thumb that illustrates the power of compound interest over time.  The “rule of 72” basically says to determine the approximate number of years an investment will take to double in value, you divide 72 into the annual average rate of return earned on the investment.  So basically,  if an investment earns a 10% rate of return it will double approximately every seven years (72 divided by 10 is just about 7).  An investment that doubles every 7 years, will double twice over 14 years, quadrupling your account value.   You can see over time how this snow-ball effect works.  After 35 years of saving, your account could potentially double 32 times.

Wow, that’s crazy to imagine, but this is part of the mindset that you need to have to secure long-term wealth with limited resources.  The average middle-class worker really can manifest some serious wealth with compound interest.  This is why it’s so important to start saving today.  Obviously the younger you are, the better off you are, because you have time on your side.  The more years you can take advantage of compound interest, the better.  Start saving whatever you can at first, even 1% of your paycheck will get you in the right direction.  Then start adding an additional % of your pay whenever you can.  Imagine yourself getting to a point where you can invest 50% or more of your paycheck!  Can you imagine how much wealth you can accumulate when you dedicate that type of income to your investments?

Take a look at some of the investment tips that we have discussed on and do your own research to help you try to achieve the best possible return on your money.  The better the rate of return on your investment, the more you can accumulate faster.  Historically the stock market over time has produced solid 10% returns.  Determine what the best investment vehicle will be for you….a brokerage account, IRA, Mutual Funds, 401k, real estate/rental income….maybe eventually all of these will be a part of your portfolio (I hope so!).

Stay focused on your long-term goals and start saving today.  Before you know it, 10, 20, 30 years go by.  If you start the process and stay on track, you will set yourself up for financial success and true wealth building.


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