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How to Use Compound Interest to Build a Fortune

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Do you often wish you could make a lot more money without doing so much?

Well, it is actually possible if you put your money to work for you. Compound interest is a simple concept that can help you build wealth. And no, it’s not a get rich quick scheme. It’s actually a get rich scheme that has been used by many to get rich, albeit SLOWLY.

So, what’s all the hullabaloo regarding compound interest?

Compound interest is a big deal. You see, there are only 2 ways you can earn interest on your investment – compound interest or simple interest.

Simple interest is calculated by multiplying the interest rate by the principal of the investment.

simple interest

Compound interest is a different beast. The interest is computed by multiplying the rate of interest by the principal and the accumulated unpaid interest.

compound interest

 

What this means is that you get to earn interest on your interest. This simple difference is enough to whet the appetite of any investor who understands its power.

Below are some tips to help you take advantage of compounding.

Start Early

Compound interest is more of a “the early bird catches the worm” than a “better late than never” scenario. While you will still make money if you start later, the differences in earnings are in the multiples.

When you’re young, you probably think you still have time. However, the best time to start is now. Don’t focus too much on making sophisticated investments at this stage. Instead, you should make a habit of saving diligently. You can put in stocks, mutual funds or a savings account.  It really doesn’t matter where you put it as long as you’re saving consistently and earning compound interest.

Live frugally and save most of your money since you have very few commitments – this is assuming don’t have a family. Challenge yourself to increase your savings every month. An amount as small as an additional $50 to what you normally contribute can make a huge difference over time. Doing this over a period of 10 – 30 years years puts you well ahead of many of your peers.

The earlier you start the better it is for you. The figure below illustrates the growth of the savings of 3 people who saved the same amount over a period of 10 years. The only difference is when they started.

 

 

The Snowball Effect of Compound Interest

To realize decent returns on your investment, you would need to save for at least 25 years. You should, therefore, be patient as the payout would be tremendous towards the tail end of your savings years. At this point, your returns will have overtaken your monthly savings and will be driving the growth of your investment. An annual rate of 4% can get you an impressive yield on your investment.

If after saving for 25 years you’ve hit the $1 million mark, a conservative return of 4% will yield an impressive $40,000 per annum. If you do not add a single penny for the next 5 years, you will have a total of $1,216,654 by the time you hit the 30th year. The best part about this is you don’t have to do much to grow your portfolio. The snowball effect will cater for your savings goals. At this point, you can sit back and enjoy the fruits of your labor.

While waiting all those years might sound a bit unrealistic, here is an illustration showing how powerful compounding can be. The graph is based on Warren Buffet’s value over the last 50 years.

 

 

Mind blowing, right? Let’s now examine some of the factors that can affect the growth of your investment.

Factors That Determine the Returns of Your Compounded Savings

  • Interest Rate – Try to get a good interest rate on your investment. A small difference can make a huge impact down the road.
  • Time – the longer you invest the more you make. Make it a habit to put away some money every month and try not to drop off at any point.
  • Tax rate – As it is with all other income, the taxman will be coming for his pound of flesh. The best way to approach this is to pick an investment option that allows you to pay tax after the end of compounding as opposed to every end of the year.

 

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