Albert Einstein called it "the greatest mathematical discovery of all time."
For those who carry hefty debt on their monthly credit card bill, Einstein's law of financial physics is not good news. But for the savvy investor, the principles of compound interest can be used to make a substantial amount of money over time.
To tap into the money-making magic of compound interest, it's crucial to first understand what compound interest is and how it works.
Financially speaking, compounding is the exponential increase of an investment. But in simpler terms, compounding is interest you earn on interest.
For example, let's say you put $2,000 in the bank. If interest is paid 5% annually, the bank will give you about $100 in interest for the first year of your investment. If you leave that $100 in your account, it will start earning interest, too. The following year, your $2,100 principal balance will earn $105 in interest. Over time, this phenomenon turns into the powerful magic of compound interest.
Here are some important ways to make compound interest work to your advantage:
Use the power of time: Compound interest is most powerful over a long period of time. Looking at the above example, your $2,000 initial investment would double in about 14 years. If all the money remained untouched, it would earn twice as much interest between years 15 through 28. In year 29, you'd effectively be earning 20% interest on the original investment (sometimes called "yield on cost"), all without needing to lift a finger.
See for yourself:
The earlier you start, the better: Whether you're in your mid-30s or mid-60s, it's never too late to start saving. If you can afford to put away even $100 a month, starting now, compound interest will duly reward you -- even in today's low interest-rate environment.
For example, at age 33, a $100 per month ($1,200 annual) contribution at a 1.5% annual interest will turn into nearly $60,000 by age 70. If you start at age 66, then this same investment amounts to just $5,000. Still, not bad. But, it clearly demonstrates that the longer you can let your investment sit and earn interest, the better.
Maximize your "compounding periods": The more frequently interest is paid, the more quickly wealth will build. Interest that compounds monthly will grow faster than interest that compounds quarterly or yearly. Therefore, to quickly obtain wealth, always chose the shortest compounding period you can.
Earn interest, don't pay it: Compound interest can work the other way, too. A typical credit card company charges 20% monthly interest on unpaid balances.