Are You Using the Benefits of Compounding Interest?

A couple goes over their financial documents at home: compounding interest

Investing may not have been top of mind when you were younger. However, the sooner you invest for tomorrow, the more potential you have to see the benefits of compounding interest unfold. It could help you build a strong financial foundation and reach your long-term savings goals. Learn more about how it works and how you could put it to work for you.

What Is Compounding Interest?

There always seems to be a reason to postpone getting serious about investing for the future. But this choice could cost you: One of the primary benefits lies in the fact that you're earning interest on interest. The more time you have to save, the more growth potential you may have.

Picture two line graphs: One graph has a straight line angled upward, while the other graph has a line that curves upward and gets steeper over time. The straight graph represents how non-compounding interest, also known as simple interest, builds your savings — similar to when you put money aside and it grows over time as you save. The curved graph represents how compounding interest works — when you put money into an account with compounding interest, the return helps your money multiply over time.

For example, let's imagine you put $5,000 into an account with compounding interest that has a 6 percent return — and you let the money sit there for 25 years. Without putting anything else into the account, you could have just under $22,000 at the end of that period because the return is calculated using both the amount of the original investment and accumulated interest. The compounding effect is primarily about time, but another critical driver is the interest rate, or investment growth rate, on your savings. The higher the rate of return, the bigger the potential compounding advantage. That's compounding interest in a nutshell.

Now, suppose you put that same $5,000 into an account with simple interest instead. With simple interest, you would only receive interest on your original investment every year. In this example, $300 (6 percent of the initial $5,000 contribution) would be added to the value of your investment annually. At the end of that 25-year period, you could wind up with $7,500 in total interest added to your original $5,000 investment, giving you a total of $12,500 — a lot less than $22,000!

Now, let's imagine you saved $500 every month — or $6,000 a year — starting at age 25. Assuming a 6 percent annual rate of return, 40 years later you could wind up with nearly $1 million using compounding interest. (And if you saved twice as much every year, your accumulations could also be double at each stage.) For these examples, we're not taking taxes and wild swings in the annual rate of return on your savings into account. The point is not to predict investment returns, but to show the potential impact of compounding interest on your savings.

Make the Most of Life

If you harness it soon enough, compounding interest could help improve your quality of life — both now and later. If you get off to a late start (and limit your ability to take advantage of compounding interest), you may be concerned about your future. A financial representative can help you get on the right track by helping you plan for what tomorrow may bring.

When you take advantage of compounding interest, you might be able to do things when you retire that those who don't leverage compounding interest can't. If you get off to an early start, you could have peace of mind in knowing you're on track to retire on your terms. When you're retired, you could have more time and money to do a number of things you held off on earlier in life — from visiting loved ones, taking faraway trips and pursuing hobbies to supporting charities (or grandchildren) and leaving a legacy.

As the old saying goes, money can't buy you happiness. However, the peace of mind that comes with having a strong financial foundation is priceless. So, consider putting compounding interest to work for you.

Information provided is general and educational in nature. It is not intended to be, and should not be construed as, legal or tax advice. Western & Southern Financial Group and its member companies (“the Company”) does not provide legal or tax advice. Laws of a specific state or laws relevant to a particular situation may affect the applicability, accuracy, or completeness of this information. Federal and state laws and regulations are complex and are subject to change. The Company makes no warranties with regard to the information or results obtained by its use. The Company disclaims any liability arising out of your use of, or reliance on, the information. Consult an attorney or tax advisor regarding your specific legal or tax situation.

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