This is a special post from Miranda, a freelance writer and professional blogger covering financial topics. You can find her at her blog: Planting Money Seeds.
When many of us think of interest, our thoughts go to credit cards and high interest rates. While compound interest can, indeed, be problematic, the truth is that, like so much in the financial world, interest can be a millstone or a tool.
Paying compound interest is no fun. When you are paying interest to someone else, your resources are going directly to enrich others. You receive no benefit – beyond the fact that you were able to borrow money – when you pay interest. This is why you should try to be on the receiving end of interest.
What is Compound Interest?
Compound interest is basically interest that you earn on interest. With credit cards, your interest charges are added to your balance, and then you pay interest on it. Compound interest works the other way, too.
There are certain products that will pay you interest on the interest you earn. Various banking products often offer this ability. When you have a savings account, your monthly compound interest means that, each month, the interest you earned is added to your balance. During the next month, that interest you received is now earning its own yield.
Investments can also earn you compound interest. As the value of your investments increase, you can use your returns to buy more of an asset, and use that money to keep earning for the future. Even if you just follow a dollar cost averaging strategy, the more you buy, adding to your portfolio, the greater your potential returns.
One of the best strategies, though, is to use dividend stocks. Reinvest the dividends, and reap the benefits. For those who don’t like stock picking, there are index funds and income ETFs that pay dividends and automatically reinvest them.
Compound Interest Can Be Your Friend
Over time, compound interest can actually be your friend. As long as you take steps to ensure that you are earning interest and not paying it, compound interest can help you build wealth. Because of the way compound interest works, your gains build on themselves, helping you increase your wealth at a faster rate over time.
In fact, without the help of compound interest, it is unlikely that you will reach your long-term retirement and wealth goals. It’s the most efficient way to amass a solid nest egg.
Achieve Best Results from Compound Interest
Compound interest can help you build your portfolio at a better rate, and help you improve your long-term prospects for wealth. But it doesn’t just happen; you need to create a plan to help you achieve the best possible results from compound interest:
- Start early: The earlier you start, the better compound interest works for you. Starting just five years sooner can mean tens of thousands of dollars more in the long run.
- Choose accounts that compound more frequently: Accounts that are compounded more frequently offer the best results. Some savings accounts compound daily, and those provide you better results than those compounded monthly or quarterly, since your interest is busy earning more interest.
- Invest consistently: One of the keys to maximizing the effects of compound interest is to invest consistently. If you start early, and invest regularly, you can turn $50 or $100 or $200 to good account over time.
- Don’t just rely on the “safest” investments: While many cash accounts offer you the ability to earn compound interest, you won’t see huge success – especially if you only put in small amounts of money. Instead, you need to add some risk to your portfolio. Don’t forget index funds and carefully considered dividend stocks.
- Keep your money in the account: The longer you can keep your money in your account, compounding, the better off you are. Use a tax-advantaged retirement account for a dividend paying investment, and you can increase the benefits even more.
With a little planning and consistency, you can put your money to work for you, building wealth through compound interest.
This post was originally published on October 10, 2012 and updated on November 20, 2020.