Have you ever heard the phrase “making your money work for you?”
Having your money make money on its own is an attractive proposition, and it’s what compounding does for your savings and investments.
Compounding is when the earnings or interest on an asset are reinvested to generate additional earnings or interest. Basically, it’s producing interest on interest (for savings accounts) or earnings on earnings (for investments) and creating a snowball effect. Let’s say you invested $10,000 in an investment that returns 5% annually. The first year you would make $500 for a total balance of $10,500; the second year you would make $525 ($10,500 multiplied by 5%) and so on. After 30 years, the investment would be worth more than $40,000, without any additional principal contributions. Compounded earnings are based on the principal plus any cumulative income generated over previous periods, essentially creating exponential growth.
Where Compounding is Used
Savings accounts, certificates of deposit (CDs), money markets, mutual funds, 401(k)s and IRAs, to name a few, all rely on the power of compounding to potentially create wealth for investors. As the chart above shows, compounding gains steam as time passes. Savings accounts pay compounded interest to investors while investment accounts reinvest the principal and earnings for compounded earnings.
How Compounding Affects Retirement
Because compounding is a function of time, it creates the most profit when applied over long periods, which is especially useful for retirement accounts. When it comes to retirement saving, the common advice is to start as soon as possible and that’s based on the premise that compounding has 40 years to “work its magic” and help grow investment accounts. While many young adults embarking on their career may not have much cash to spare with student loans and entry-level salaries, they do have one thing on their side – time. Because of the compounding effect, investments, even small ones, during this period may have higher growth potential and can potentially make a sizable difference in the ultimate balance of a retirement account.
For more information on which financial vehicle you may want to use to create compounded growth for your money, talk to your financial advisor.
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