stacks of coins with plants growing showing money growing with compound interest
Compound interest can be a superpower for savers and investors. Conversely it can be your kryptonite when you are in debt.

Compound interest is a powerful tool for building wealth. It’s also a devastating tool that can destroy wealth. Whether you love it or hate It depends on which side of the financial equation you use it. Compound interest can work for or against you.  When you invest or save, compound interest helps your money multiply over time.  However, when you’re in debt, it can make you more in debt.

Understanding Compound Interest

Unlike simple interest, compound interest lets your returns earn returns of their own. Money invested in the stock market and in savings accounts may benefit from compound interest. Thanks to its potential to grow savings over time, the idea of compound interest is what motivates many people to start investing. The longer you stay invested, the more time your money has to benefit from compound interest.

Compound interest is when the interest you earn on an investment or savings account itself earns interest over time. It’s the interest on your interest.  On the love it side – your money makes you more money. On the hate it side – your debt can make you more in debt.

Savings Accounts and Compound Interest

Imagine you deposit $10,000 into a savings account with a 4% annual interest rate. Here’s an example of how it grows over time:

  • Year 1: By the end of year 1, you’d have $10,400 (assuming daily compounding).
  • Year 2: Your balance would grow to $10,816.
  • Year 10: Due to the superpower of compound interest, you’d have $14,233 by the end of year 10 without making any additional deposits.

The key takeaway: Compound interest allows your money to grow even without additional contributions. It’s like planting a money tree that sprouts more money each year.

Stock Dividends and Compound Interest

Compound interest is a financial superpower that can significantly enhance your wealth when reinvesting dividends. Dividends are payments made by companies to their shareholders. When you own dividend-paying stocks, you receive these regular cash payments. Reinvesting dividends means using these cash dividends to buy more shares of the same stock. These new shares also generate dividends.

Stock Dividend Example

Let’s say you own 100 shares of ABC Corp, and each share pays a $1 dividend annually.  Each year instead of taking the dividend payout in cash you reinvest it to buy more shares in ABC Corp.

  • Year 1: Instead of taking the $100 in cash, you reinvest it to buy 5 more shares (at $20 per share).
  • Year 2: You now own 105 shares and receive dividends of $105 to buy 5.3 more shares ($1 dividend payout per share)
  • Year 10: Due to reinvesting, you now own 155 shares and receive dividends of $155.

If ABC Corp’s stock price stayed steady at $20 per share for the whole ten years, you end up with $3,100 (155 shares * $20 per share). You started with $2,000 (100 shares at $20 per share.) Most likely the stock would also appreciate during that time. Also, most successful companies increase their dividends over time.

Debt and Compound Interest

Compound interest is like a snowball rolling downhill—it grows as it accumulates.

Remember, compound interest isn’t always your ally. When you’re in debt, it can work against you.  Say you have a credit card like the Chase Amazon Prime card.  It charges 19.5% interest (which can go up to 29.99% if you get behind and have penalties.).  Let’s say you owe $5,000 in credit card debt and make only the minimum payment due of 1% of the statement balance and interest.  You pay on time so there aren’t other fees or past-due amounts.

  • Year 1: Over the first 12 months you have $947 of interest added to your debt.  After making 12 months of payments, you will have paid $1,515. At the end of year 1 you still owe $4,432
  • Year 2: Over the first 24 months you have $1,720 of interest added to your debt.  After making 24 months of minimum payments, you paid $2,858 in total.  At the end of year 2 you still owe $3,928.
  • Year 10: Over the first 120 months you have $5,839 of interest added to your debt.  You have paid $9,342 total in the 120 monthly payments.  At the end of year 10 you still owe $1,497.

When only making the minimum payment it will take you 277 months or 23 years to pay off this $5,000 debt.  Over that time, you will have paid $7,724 in interest. That is more than 150% the original debt.

That is the negative power of compound interest!

Here is a minimum payment of credit card calculator you can use to figure it out for your own debt.  You will need to know the minimum amount your credit card issuer requires you to pay on your balance each month.  It is typically some percentage of the balance.  You also need to know the interest rate for your credit card.  You usually can call the number on the back of your credit card and the customer service agent will give you this information if you don’t already know it.

Credit Card Minimum Payment Calculator – Forbes Advisor

Conclusion

Use compound interest to your advantage by investing early and consistently.  Be cautious or avoid debt.  Compound interest can amplify debt.  Compound interest’s magic lies in time.  The longer your money stays invested, the more it grows.  On the other hand, debt compounds and grows when left unpaid.

Remember Money makes money, and the money that money makes, makes more money!  Compound interest is a money-making superpower. Use it for saving and investing and it is a superpower.

Disclaimer: The examples provided are for illustrative purposes only and do not represent specific recommendations. Always consider your individual financial situation and consult a professional advisor.

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