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Compounding Interest: Your Greatest Ally and Your Worst Enemy

By Megan Kowalski on March 14, 2022

Compounding interest may be a familiar term to many but understanding its true power is most imperative. In fact, Albert Einstein has even been quoted for naming it as the eighth wonder of the world. Building off our last post on taking the first step with investing, this blog will further highlight why starting sooner rather than later is so vital.

So what is compounding interest?

Compound interest is the accumulation that builds up from the interest-on-interest return over time. It is when your earnings are reinvested and have increased your investment base. Let’s look at an example where an investment earns a 10% return per year and each year’s earnings are reinvested.

AgeYearBeginning BalanceGainYear-End Balance
200$ 10,000.00$ 1,000.00$ 11,000.00
211$ 11,000.00$ 1,100.00$ 12,100.00
222$ 12,100.00$ 1,210.00$ 13,310.00
233$ 13,310.00$ 1,331.00$ 14,641.00
244$ 14,641.00$ 1,464.10$ 16,105.10
255$ 16,105.10$ 1,610.51$ 17,715.61
266$ 17,715.61$ 1,771.56$ 19,487.17
277$ 19,487.17$ 1,948.72$ 21,435.89
288$ 21,435.89$ 2,143.59$ 23,579.48
299$ 23,579.48$ 2,357.95$ 25,937.42
3010$ 25,937.42$ 2,593.74$ 28,531.17
4020$ 67,275.00$ 6,727.50$ 74,002.50

As illustrated above, not only does the investor benefit from the return on the original principal each year, but they also benefit from the return that preceding years’ interest generates. Below is a visual of how the investor generates a return over a 20-year period.

The most powerful factor from the investment is the compounding interest. The principal only grows through contributions or by investment return. The compounding allows the investor to make money on the original principal as well as all on the interest that has been earned and reinvested. This allows the investment to grow at an accelerating rate as shown above.

Great, we love compounding interest! No, not so fast.

As powerful as compounding interest is for investments, it can be equally as destructive when it is used against you. Take credit card interest for example.

As we can see, compounding interest can be a very powerful tool when used to grow your investments. The key is to make sure it is working for you and not against you as it can be your greatest ally and your worst enemy.

I hope that today’s blog has helped sharpe-n your knowledge of the investment landscape. If you have any topic suggestions or have further questions, please reach out to mkowalski@hightoweradvisors.com.

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The Lerner Group is a group comprised of investment professionals registered with Hightower Advisors, LLC, an SEC registered investment adviser. Some investment professionals may also be registered with Hightower Securities, LLC (member FINRA and SIPC). Advisory services are offered through Hightower Advisors, LLC. Securities are offered through Hightower Securities, LLC.

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