Compound interest, or compounding interest, is the financial concept that can literally change your life. It is the way that ANYONE can become a millionaire and save for retirement. Of course, like any financial concept, the principle has to be used correctly.

So what is compounding interest?

Compounding interest is the money, or interest, that grows on top of your investment (or loan). So basically it is the money that grows on your money, including the interest that you gained. The growth of your account balance accelerates over time as you earn interest on increasingly larger balances. So initially you may see fairly small returns but over time the growth becomes rapid.

So using a simple compound interest calculator, shows how a $50,000 one-time investment over 40 years can grow to $1,086,226.07, by gaining 8% interest per year. Now that is a relatively long time horizon and some of us do not have that long to grow our money, but the principle still stands no matter what the individual factors are. Time, investment amount, interest rate, and frequency of compounding can all affect the return amount. Interest can be compounded daily, weekly, monthly, or annually and each method affects the return differently. The more frequently interest is compounded the more rapidly the account balance will grow.

For those with lower time horizons, compound interest can still be vastly beneficial. Contributing $50,000 would grow to $73,466.40 at 8% interest within 5 years, $107,946.25 within 10 years, and $233,047.86 within 20 years. This is one of the reasons why financial advisors always recommend starting investing in retirement early.

Compound interest is the primary reason that the stock market is so attractive to many people. You can put a smaller sum of money into a fund and grow it with little to no effort, just by having the right information. Many people position their 401(k) or work retirement accounts, or IRAs, into the stock market so they can see large growth by the time to retire comes near.

Compound interest is closely tied to the time value of money and the Rule of 72, both of which are important concepts in investing and finance.

Source: Compound interest calculator provided by Investor.gov, as of January 21, 2022. This hypothetical example is for illustrative purposes only and assumes the following: (1) starting investment of $50,000; (2) no additional pre-tax contributions; (3) an annual rate of return of 8%; (4) the ending values do not reflect taxes, fees or inflation.

Can compounding interest work against you?

Absolutely. If you borrow money, such as a mortgage, credit cards, student loans, or any other form of loan compounding interest can work against you. That is why it is so hard to pay off a credit card bill once interest starts accruing on it. It is important to avoid high-interest loans whenever possible and to pay off the balances as quickly as possible when it is necessary. This is one of the main causes of people being in debt throughout their lives.

Key Points:

• Invest as early as you can to give yourself a larger time horizon

• Be aware of how the interest is being compounded and try to maximize your options

• Pay off high-interest debts to avoid compound interest hurting you