Compound Interest: How It Works In Building Wealth

Compound interest is a fundamental concept in personal finance that can be utilized to generate long-term wealth through the ability to let your money work for you. Compound interest allows for exponential growth of investments, hence the phrase "the power of compound interest." The more frequently the interest is compounded, the faster the investment will grow. This is because with more frequent compounding, there will be more added interest to the principal amount, which leads to more interest being earned on that interest. As a result, the investment grows faster over time helping you reach your financial goals.

Understanding How Compound Interest Works

It is important to first understand the difference between simple and compound interest. Simple interest is calculated only on the principal amount, whereas compound interest is calculated on both the principal and the interest earned. One of the key differences between compound interest and simple interest is the time period. Simple interest is usually calculated based on a fixed period, regardless of the amount of time the money has been invested. In contrast, compound interest is based on the amount of time the money is invested. The longer the investment period, the higher the returns from compound interest.

Compound interest is an essential concept for investors to grasp as it allows for exponential growth of investments over time. Understanding how compound interest works can help in making informed investment choices. To start becoming familiar with how compound interest works, one must first understand the variables in the compound interest formula. This formula involves four main variables: the starting principal amount, the interest rate, the frequency of compounding, and the duration of the investment. It's important to understand how each of these variables affects the overall outcome of an investment. By doing so, they can gain the maximum advantage from compound interest and achieve their financial goals.

The principal amount refers to the initial sum of money invested. The interest rate is a percentage of the principal amount that is added to the investment each year. The frequency of compounding refers to how often the interest is added to the investment, which can be daily, monthly, quarterly, or annually. The more frequent the compounding, the faster the investment will grow resulting in higher returns. For instance, an investment with monthly compounding will yield faster growth than an investment with quarterly compounding.

Starting with a larger principal can have many benefits when it comes to building wealth with compound interest. A larger principal means that the potential earnings will be higher, resulting in greater wealth accumulation over time. For instance, if two individuals invest in the same investment vehicle, but one starts with a higher principal, they will earn more interest than the individual with a smaller starting principal. Additionally, a larger principal can help individuals reach their short-term financial goals faster, as they have more money available for investment.

Lastly, the duration refers to the time frame for which the investment will grow. Investments need time to compound in order for the returns to grow. For example, consider a self-directed IRA account with an investment that has an interest rate of 5%. If an individual opens the account with a $10,000 initial investment and leaves it untouched for 10 years, they will earn approximately $6,386 in compound interest on that investment. However, if they hold that investment in the account for 20 years, they will earn approximately $16,386 in compound interest. Add the fact that these investments are being conducting inside of a retirement account, those profits are also growing either tax-deferred or potentially tax-free. This illustrates how the duration of an investment can greatly impact the power of compound interest and help you achieve your long-term financial goals.

How It's Calculated

The most important aspect of understanding compound interest is the compound interest formula. Each component of the formula plays an important role in calculating the future value of investments. To calculate how much compound interest you would receive over time, you can use this compound interest calculator from investor.gov. This is a great tool to help you with your financial planning.

Creating Generational Wealth with Compound Interest

While compound growth can benefit anyone who starts early and holds quality investments for a long period of time, it can also be used to create generational wealth that can benefit not just the current investor, but also their children and grandchildren. Using the concept of compound interest to create generational wealth is a smart strategy that can help individuals and families build long-term wealth that can benefit future generations by being passed down.

For example, if you start with $10,000 and add a $300 monthly deposit, you'll have contributed $82,000 in 20 years, but with an estimated 5% interest rate compounded annually, your money will have grown to over $145,500. If you increase your contribution to $500 per month with the same interest rate and the same duration, your investment will now be worth $241,197! Small changes in contributions, interest rates and duration can make a huge impact on the long-term growth of your investments and the ability to reach your savings goals. 

One way to take advantage of compound growth is through tax-advantaged retirement accounts, such as self-directed IRAs, Health Savings Accounts (HSA), Coverdell Education Savings Accounts (ESA) and 401(k)s. These accounts allow investors to contribute pre-tax dollars, which can reduce their taxable income and potentially save them thousands of dollars in taxes over the course of their career. In addition, gains in these accounts are tax-deferred until they are withdrawn, which can further boost investment returns. Some accounts, like the Roth IRA, even grow profits tax-free!

To maximize investment returns and create generational wealth, investors should diversify their investments across a range of asset classes, private and public, and custodians like Quest offer alternative investment solutions. By starting early, investing in quality companies, taking advantage of tax-advantaged retirement accounts and employer-provided plans, diversifying investments, and utilizing dollar-cost averaging, investors can maximize returns and create a legacy of wealth for their loved ones.

Understanding how compound interest works is extremely important when devising a financial plan to work toward financial freedom. Small differences in interest rates, compounding frequency, and investment duration can have a big impact on the final value of an investment. By understanding the compound interest formula and how it's calculated, individuals can make informed decisions and maximize the power of compound interest. When investing, careful consideration should be taken, but if you ever have questions about self-directed IRAs or setting up a retirement plan, reach out to an IRA Specialist and schedule a 1 on 1 consultation today.