How Does Compound Interest Work? And How Can You Make it Work for You?

In the personal finance world, there are few concepts that can help you snowball your wealth and propel you towards your financial goals faster than compound interest.

By consistently investing, even small amounts, you can watch your savings multiply and build wealth for your future.

If you care about long-term financial success and potentially financial freedom, this is an important concept to make sure you understand and include in your financial strategy.

If you’re wondering, “How does compound interest work? And how can I make it work for me?” Then you’re in luck!

I’m going to dive into the ins and outs of compound interest and its importance in building a solid financial foundation. I’m going to explain how it works, why it matters, and most importantly, how you can leverage this powerful concept to set yourself up for long-term financial growth.

Finally, if the idea of using compound interest has piqued your INTEREST (get it?), be sure to check out our free masterclass, where we teach you the principles of building financial wellness through investing.

How does compound interest work? (And why is it important?)

First off, what is compound interest?

Compound interest is when you earn interest on both the initial invested amount AND any accumulated interest that has already been earned. In other words, your interest is calculated and added to the principal, and then future interest is earned on the combined total.

You can think of compound interest as "interest on interest" – the interest earned in each period is reinvested and contributes to the growth of the investment.

For example, let’s say you invest $10,000 in an investment that offers an annual interest rate of 5%. The interest is compounded annually.

After the first year, your investment would earn 5% interest, resulting in an additional $500 in interest. At the end of the year, your investment would grow to $10,500.

In the second year, the 5% interest rate is applied to the new balance of $10,500. This would yield $525 in interest. Thus, at the end of the second year, your investment would grow to $11,025.

The compounding effect continues with each subsequent year. Over time, the growth becomes more significant due to the accumulation of interest on both the initial investment and the previously earned interest.

After 10 years, your initial $10,000 investment would grow to more than $16,000, assuming no additional contributions or withdrawals are made. That's an increase of over 60% solely due to the power of compound interest!

Compound interest plays a vital role in long-term investment growth, because it allows your money to grow exponentially over time.

We refer to compound interest as the avalanche of investing, because once it gets going, it really gets going and you want to get out of its way and let it do its thing!

6 ways to make compound interest work for you

1. Start ASAP

The key to maximizing the benefits of compound interest is to start investing or saving as early as possible. The longer your money has to compound, the bigger it grows. Even small amounts invested or saved consistently over a long period can grow substantially due to compounding.

The key factors that influence compound interest are:

• the principal amount: the initial amount you invest
• the interest rate: the return on your investment
• the compounding period: how long you have to leave your money invested

To maximize the benefits of compound interest, it's important to start investing or saving early and consistently, and allow your money to compound over a long period. By doing so, even small contributions or investments can grow significantly over time.

2. Contribute to your investments regularly

Consistently investing or saving money on a regular basis allows you to take advantage of compounding. Set up a systematic investment plan or automatic savings plan where you contribute a fixed amount at regular intervals. This ensures a steady stream of contributions, which compounds over time.

As your income grows or your financial situation improves, consider increasing the amount you contribute to your investments. By increasing your contributions, you accelerate the growth potential and compounding effect on your investments.

3. Reinvest your dividends and interest payments

If you invest in assets that generate dividends or interest, consider reinvesting those earnings back into your investment. Reinvesting dividends or interest allows them to compound and generate additional returns over time, accelerating the growth of your investment.

4. Choose investments with compound growth

Look for investments that have the potential for compound growth. Stocks, mutual funds, index funds, and other investment vehicles that have historically provided solid returns can be great choices for long-term financial growth and compounding.

5. Be patient, don’t panic, and stay invested

Compound interest is most effective when it's allowed to work over the long term.

Unfortunately, when the market is down, people get scared and are tempted to sell their investments.

For example, during the 2008 recession, people panicked and sold their investments at a loss. If they kept their money in their investments, then their money would have continued to grow and those investments would have been worth thousands more today.

In short: avoid making frequent changes to your investment strategy based on short-term market fluctuations.

Instead, stay invested, maintain a long-term perspective, and resist the temptation to time the market. This approach allows your investments to benefit from the compounding effect.

6. Take advantage of tax-advantaged accounts

Put your savings in tax-advantaged accounts like Individual Retirement Accounts (IRAs), 401(k)s, or Health Savings Accounts (HSAs) in the US, or RRSPs or TFSAs in Canada.

These accounts provide tax benefits that can enhance the compounding of your investments.

Contributions to these accounts may be tax-deductible, and investment gains can grow tax-deferred or even tax-free, depending on the account type.

But compound interest isn’t always good…

Remember that compound interest is not a magic solution that guarantees high returns or eliminates investment risks. It's important to understand the potential risks and rewards associated with your investments and make informed decisions based on your individual circumstances and risk tolerance.

By starting early, investing consistently, and allowing time for your investments to compound, you can harness the power of compound interest to potentially grow your wealth over the long term.

And if you have credit card debt, you need to know that compound interest is currently working against you! Most credit card companies charge high compounding interest, which is why paying off credit card debt is so difficult. Imagining being under the avalanche - that’s what credit card debt is like.

If this is you, I want you to check out our free masterclass right away -  in it, Laurie-Anne tells her story of going from $40,000 in debt to making thousands of dollars every month from her investments.

We LOVE helping people get out of debt - and changing their relationship with compound interest to one that holds them back, to one that helps them win at the financial game of life.