What is Compound Interest and Why do I Care?
If you've ever researched topics related to long-term investing, retirement planning, etc. you've probably heard the term "compound interest." In fact you've probably heard the term a lot, and it may seem like the only topic people want to talk about regarding planning around our finances. Well if you've ever asked yourself "What is compound interest and why the hell do I care?" we are going to get that question answered. Let's talk about it.
Compound interest might be the most powerful tool that we have at our disposal when planning for the long term. Over time, compounding is what can often be accredited with the massive growth in our portfolios. Without it, our rate of return/growth would look much more linear as opposed to exponential (don't worry I'll explain).
What is Compound Interest?
Compound interest can be described as the addition of interest to our principal or original amount/balance. Another way to describe it would be interest earned on previous interest. It's this interest on interest that equates to such large growth in a long term portfolio. To put it simply, when we re-invest the money we make, we can then make money on the original amount, and make money on the interest we re-invested. Let's look at a graph to help us visualize this.
Look at the graph above and you'll notice the difference in growth rates between compound and simple interest.
This picture really represents the difference in linear growth and exponential growth. We see a huge difference in the growth rate near the end of the graph with our compound interest. This is what we would consider exponential growth. Whereas with the simple interest, the growth amount is the same every year, otherwise known as linear growth.
So how does this affect our portfolio? When we take the time to create a sound portfolio, and allow our money to be in the market for the long-term, we get the benefit of compound interest and exponential growth. While the growth during the early stages seems minimal, after a period of time we begin to see rapid growth, which allows us to experience the greatest overall returns. It's the years at the tail end of our portfolio's life when returns really start multiplying and our overall balance really begins to grow.
Compound interest is an incredibly powerful tool that we should all be implementing, whether it be in a standard investment account, retirement account, savings account, etc. It takes time and discipline, but is what really gives us the opportunity to grow and increase our wealth.
Whether you're ready to begin, or have already started putting money away for the long term, let's talk, create a plan, and make sure you're reaping the benefits of compound interest. It will certainly pay off in the future.
Tanner Millar
Investment Advisor - Core Planning
tanner@yourcoreplan.com
(660)-998-4639
https://www.yourcoreplan.com/disclosures