What Compounding Interest Is and Why It Can Change Your Life

You’re making money because of your money.

As if making money wasn’t easy enough, scientist have created a method to grow your money exponentially!

No that isn’t true at all. In fact, compounding interest has been around for some time. As of recently, the investment vehicles that compounding interest can work on has dramatically changed. If you are familiar with the compounding interest concept, you most likely heard it first when you opened up your first bank account. Imagine little billy with his propeller hat cradling a piggy bank full of change and a few folded bills. His parents take him down to their local bank and ask the teller to open up a new savings account. The parents explain to billy “Now we are going to open up this account for you, and the older you grow, the more money you’ll earn! All because you opened a savings account. If you keep saving your money, one day you’ll be earning more money because you chose to save it.” Billy’s parents vaguely described what compounding interest is to him, but man is he in for a rude awakening 10 years from now. That measly change that Billy saved isn’t going to earn him squat. Considering how low the interest rate is for many banks, he is more than likely earning somewhere in the ballpark of .05-.09% on his principle. Mr. and Mrs. Billy, just buy the kid a freaking T-bill! He would make so much more money!

I’ll just give you Wikipedia’s explanation of what compounding interest is. It is the addition of interest to the principle sum of a loan or deposit. In this case we are figuring out the addition of interest to a deposit. The short version of this is simple, compounding interest is a tool that will make you rich. It is just how you use it that will define you as an investor. Instead of relying on the compounding interest of a bank, consider relying on the compounding interest of stocks. Here’s something to consider. Let’s say I have a decently sized position in AT&T. Their stock is worth (for teaching purposes) exactly $30. AT&T pays out a quarterly dividend of .50 cents. So in order for me to be able to buy 1 share of AT&T every time I receive a dividend payout (my interest), I will need to have 60 shares. How smart and simple does that sound? If you understand the value of that concept, you just got a whole lot closer to financial freedom.

In banking, we refer to compounding interest as the money earned on our initial principle inside our account. Sometimes, people refer to this as the bank paying us for saving our money with them. When it comes to stocks, your money grows in two ways. The first way is by basic appreciation of the company. If AT&T is originally worth $30 per share and a year later they are worth $35, you just made $5 per share. On top of that, you were also paid an interest rate (dividend) for taking a risk on that company four times a year. You’re growing in two places; general appreciation and interest appreciation. Can you get this same result with a savings account? No you cannot. What makes this process grow even faster is when you find securities that pay out dividends on a monthly basis. Yeah that’s right, you get paid dividends every month. But with having such a frequent payout, you have to be leery of the risk involved, and general appreciation does not occur at a rapid pace.

Receiving monthly dividends is a really attractive thing to some investors, and we will cover that in a later entry. If you play your cards right, you can maximize the way your money works for you.

Disclaimer

These are generalizations and meant to increase your understanding of the securities market. Any advice contained within this blog is general advice and does not consider your objectives, financial situation or needs, and you should consider whether it’s appropriate for you. The information we are giving you is for educational purposes only.

“Investing is about understanding your risk” and every time you invest in the share market there is a risk of loss. Trading is not for everyone. There is a possibility that you can lose your money. You should only act on our recommendations if you are confident that you fully understand what you are doing.

 

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