Many financial experts recommend investing to increase your wealth from the return on investment or interest. This is what most millionaires have done. They played their cards right and invested their money in profitable organizations and, in turn, received interest which they may reinvest to keep the income flowing and expand their wealth.
If you are someone working at a normal job and living on a paycheck, becoming a millionaire may seem like a far-off dream.
This is where you need to learn more about the compound interest phenomenon, which is the best way to build your wealth for the long term.
The most important step to becoming a millionaire is to start early. The more you start to invest early, regardless of the amount you have invested; you can have your money invested in the investment accounts for a long time which can result in you reaching your goals faster.
A misconception that most people have is that you need a lot of money to be able to invest. However, that is not true because with a small investment each month, you can accumulate wealth over time due to the compounding phenomenon.
You can use a compound interest calculator to forecast how much money you can make over time. It creates a growth projection for your investments based on the anticipated rate of return.
What is compound interest?
Compound interest, simply put, is interest on interest. Compounding means that the returns on investments become a part of investments and generate returns. It adds together all of the money that is accumulated as a result of the building interest.
Compounding can occur daily, monthly, and yearly. The arithmetic of compounding means that the investments generate disproportionately higher amounts after some years. This is why for long-term investments, compound interest can be highly rewarding.
To understand compounding a little better, here are some examples. Compound interest arises when you invest your money, for example, in shares, and then receive interest or dividends for the year on your investments, you reinvest this interest or dividend by buying more shares, and this reinvested interest will also earn interest.
The addition of interest to the principle is called compounding. For instance, you invest $100 in the bank at 10% to be compounded yearly. At the end of the first year, the total amount will be $110; of this, $10 will be the interest.
You have a choice to either use this $10 or reinvest it. If you choose to reinvest the money for the second year, you can earn interest not only on your principal investment but also on the interest. This will make your total for the second year to be $121.
This way, your total amount will keep on rising with time, and the value of time is the most important thing to appreciate about compounding. As your returns start earning, the profits start to really pile up!
How much money do you need to invest?
Well, there is no limit as to how much you need to have to be able to start investing your money. Many people don’t think about investing their money until their late 30s. However, it is highly important to start early.
Even if you start by saving as low as $5 every day, you can reach your goals as the money you save will soon add up.
Will compounding make you a millionaire?
Compounding can make you a millionaire depending on how much you invest and how early on you can start. It is always recommended that you start early. Even if you can save $5 every day into an account with a 10% annual return, it can become $2.3 million in 50 years.
If you are able to invest more than this, then this process can take you fewer years, and you can make more money. The time can reduce if you invest more. Starting now is the secret to becoming a millionaire before you retire.
Benefits of compound interest
If you are interested in long-term investments, compound interest is best suited to you. In comparison with simple interest, which is only calculated on the principal amount every year, compound interest is added to the total amount that includes interest from the year before. This gives a greater boost to your total investment after 30 years.
Savings account:
You can open a savings account in a bank that has an interest rate that is most suitable for you. The bank keeps depositing the interest to your account and notifies you of the total amount, which is the principal amount plus the interest earned.
401(k) accounts and investment accounts:
The percentage that these accounts gain depends on the stocks’ gain from day to day and is calculated based on their performance the day before. These accounts compound daily, and over time if you keep reinvesting, your balance can grow even faster.
Disadvantages of compound interest
If you are someone that needs liquid funds and cannot afford to keep your funds tied in an account for many years, then compound interest is not for you.
Sometimes the process can be more expensive than you realize. The cost is not immediately known, and you cannot closely monitor your investment. If you have taken out a loan, compound interest can negatively affect you.
Student loans and mortgages:
When you borrow money, there is a rate of interest associated with it. If you don’t pay the interest within the period stated, they are added to your additional loan balance. After this, the future interest is based on the previous interest amount and principal loan amount. This can cause you to be buried in debt if you are not able to meet your interest deadlines.
Credit cards:
Every month, a credit card charges interest on your balance on the card. If you pay the accrued interest charges on time, your balance remains the same, but if you cannot pay it on time, it will be added to your balance, and then your interest charge will be compounded.
Thus compounding can increase the value of your investments without causing you to use more of your own money.
However, it can work negatively as well for you, so it is better to pay off any debt as soon as you can so that you can start investing for the long term and save your money.
