I have eluded to compounding in previous posts but I've waited until now to talk about it as I wanted you to have a solid foundation about how to save and invest before we dive into what may be one of the best lessons you will ever learn.
According to Investopedia, compound interest (or compounding interest) is interest calculated on the initial principal, which also includes all of the accumulated interest of previous periods of a deposit or loan. For example, if you have $100 invested and earning 10% interest annually, at the end of the first year, you will have $110. Then, you will earn 10% on the $110 for the second year, leaving you with $121 after year 2. It doesn't sound like a lot at first, but over time, you will notice a dramatic difference in your savings.
One of my favorite investment calculators in on Dave Ramsey's website. After reading this post, check it out. I think it will be eye opening.
I first learned about compounding in college but it wasn't until recently that I fully began to understand how it worked as well as its inherent power. There is also a book called The Compound Effect by Darren Hardy which I want you to read. It was one of the best investments I ever made.
Basically what I learned was that Compounding + Consistency + Time = Wealth.
Determine how much you can invest each month and do so religiously. I set a reminder on my phone telling me to invest on the first of every month. Don't worry about what the stock market is doing on a given day. We are in this for the long run. Think about how much you will have 30 years from now if you invest $1,000 per month. According to Ramsey's calculator, a 35 year old with $0 in savings today can have almost $1.5 million if he or she invests $1,000 per month for the next 30 years at an interest rate of 8%. Also note that Ramsey mentions that historically, the 30-year rate of return of the S&P 500 has been roughly 12%, so based on this figure, your total net worth can actually be way higher. But let's take the conservative approach just in case.
See...isn't compounding fabulous?!