Compound interest has the potential to be very powerful, whether it’s making you money or increasing your debt. Depending on your situation, it could be a tool that can make you wealthy or a curse that holds you back from long-term financial success.
How do you best capitalize on compound interest, and how can you make it work for you?
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What Is Compound Interest?
You already know what interest is. An interest rate serves to modify a specific amount of money over time. If you have money in a bank account, you might earn a small amount of interest every year, increasing the amount of money in your account. If you have credit card debt, you might be forced to pay a certain interest rate on whatever money you owe, increasing your debt.
Compound interest is interest that begins to accrue not only on the initial principal but on the previous interest generated. Given enough time, this can lead to a powerful exponential effect, dramatically increasing the amount of money you make or the amount of money you owe.
For example, let’s say you have $10,000 in an account that generates 10 percent interest. During the first year, you’re going to generate $1,000 in interest. The next year, you’re going to have $11,000, so you’re going to earn $1,100 in interest. The amount of interest you earn will increase and increase, indefinitely, so long as your principal keeps growing.
There are many ways to make compound interest, with stocks, bonds, real estate investments, commodities, and special types of funds being some of the most common.
What are the best strategies to make compound interest work in your favor?
Paying Off Debt
It’s important to understand that compound interest works in both directions. If you have significant debt that is accumulating interest every year, you could quickly become financially crippled. That’s why one of your highest priorities should be managing your debt.
- Pay your bad debts as soon as possible: Generally speaking, you should be working to pay off your debt as soon as possible. The longer you have owed principal, the more interest you’re going to generate and the more restricted you’re going to be. Before trying to invest, make sure you’ve eliminated all your high-interest debt.
- Prioritize payments based on the interest rate: Similarly, if you have multiple debts, you should prioritize the debt with the highest interest rate first. You should also consider consolidating your debt if it means getting a lower interest rate.
- Understand and make use of good debt: Good debt is any debt that allows you to increase your net worth, or financially advantage yourself in other ways. For example, student loans and mortgages tend to have low interest rates while opening the door for more financial possibilities in the future.
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Making Compound Interest Work for You
In addition to paying off your debt, you can adjust your financial life to try and make more compound interest as you generate wealth. These are some of the best strategies to help you:
- Start early: The early stages of compound interest are barely noticeable, while the later stages of compound interest are breathtakingly powerful. That’s why it’s a good idea to start as early as possible. If you can start investing in your 20s, you’ll be set up for a very bright financial future even if you don’t make a very high salary.
- Have a plan: Put together a plan for how you’re going to invest and how that plan is going to change over time. You don’t need to know all the details, especially if you don’t have much experience right now, but you should have a general idea of the trajectory of your financial future.
- Diversify (and regularly balance) your portfolio: Next, diversify your portfolio. Some investments are going to be more attractive to you than others; for example, you may be more interested in investing in real estate than stocks. If you want to see the best results, it’s important to diversify your portfolio. In other words, hold many different assets from many different industries to improve the consistency and reliability of your returns.
- Reinvest dividends and cash flow: Many of your investments will generate cash flow or dividends. Rather than cashing out and splurging with the money, consider reinvesting it to help your principal grow even faster.
- Increase your income: Try to increase your earning potential over time as well. This will give you more capital that you can freely invest.
If you use these strategies to make compound interest work for you, you can dramatically increase your net worth over the next several years. It takes some time for compound interest to generate substantial momentum, but once you’re in a better financial position, everything will get much easier.