Why you should start investing early – Power of compound interest in finance

Few concepts are as powerful and transformative in personal finance as compound interest. This principle turns modest savings into substantial wealth over time, making it a cornerstone of successful long-term investing. Anyone seeking financial security must understand and harness compound interest. The term compound interest refers to interest earned on interest. The return on your investment is what you get when you invest. Compound interest also earns returns from previous periods’ accumulated interest. It creates an exponential growth of your money over time.

Magic of starting early

If you start investing early, your money has more time to grow through compound interest. This is why financial advisors often emphasize the importance of investing as soon as possible, even if you only invest small amounts initially. Let’s look at an example to illustrate this point:

• Investor A starts investing $200 per month at age 25 and continues until retirement at age 65.
• Investor B starts investing $400 monthly at age 35 and continues until retirement at age 65.

Assuming an average annual return of 7%, here’s how their investments would grow:

• Investor A (starting at 25) – $512,194
• Investor B (starting at 35) – $400,289

Despite investing twice as much each month, Investor B has less money at retirement because they started ten years later. This demonstrates the incredible power of compound interest and the advantage of starting early.

Rule of 72

A handy tool for understanding compound interest is the Rule of 72. The rule estimates how long it will take to double the value of your implementation. Divide 72 by your expected annual return rate to get how many years your money will take to double.

For example, if you expect an annual return of 8%:

• 72 / 8 = 9 years

Your investment would double approximately every nine years with an 8% annual return.

Strategies for maximizing compound interest

To make the most of compound interest, consider these strategies:

1. Consistent investing – No matter how small, regular investments add up over time because of compound interest. Automatically transfer money to your investment accounts.
2. Reinvest dividends – If you invest in dividend-paying stocks or funds, reinvesting those dividends significantly boosts your returns.
3. Take advantage of tax-advantaged accounts – Accounts like 401(k)s and IRAs offer tax benefits that enhance the power of compound interest. Maximize your contributions to these accounts whenever possible.
4. Avoid withdrawals – Withdrawing money from your investment accounts reduces compound interest’s power. Try to leave your investments untouched for as long as possible.
5. Increase contributions over time – As your income grows, increase your investment contributions. Even small increases have a significant impact over time.

Impact of fees on compound interest

While compound interest works in your favour, investment fees work against you. High fees significantly erode your returns over time. For example, a 1% difference in annual fees results in thousands less in your portfolio over several decades. This is why you should pay attention to investment fees. Invest in low-cost index funds and ETFs, and avoid high-fee actively managed funds. Some platforms, like those offered by vist rexas.com for info about rexas finance, provide transparent fee structures to help you understand and minimize your investment costs.