So anyone with half a brain knows how debt can get out of control. Your interest grows based on how much you owe. Let’s say you have a credit card with 16%apr carrying a $1,000 balance. By the end of the year, if you didn’t make any payments, you’d owe $1,160. Your debt grew by $160. Carrying over through the next year (not paying on debt for multiple years is certainly not recommended), that balance of $1,160 will have grown to $1,345.60. Did you see what happened there? Even though you didn’t spend any more money on the account, you’re accruing more interest debt. A total of $185.60 interest was added to the balance as opposed to $160 the previous year. What you're seeing is compounding interest.
To put it plainly, compounding interest is paying interest on interest. But it’s not just debt that has the characteristic of compounding interest. Interest also compounds in savings accounts and investment portfolios. Interest rates in savings accounts are low, typically less than 1%. So I recommend investing in the stock market to better get compounding interest to work for you. Your portfolio is what you make of it, but for demonstration purposes, I’ll be following the average S&P 500 interest gain over the last 10 years: 13.8% when using DRIP. With a $10,000 portfolio tracking the S&P 500 you’d have a value of $11,380, a gain of $1,380. Assuming you don’t buy any more securities over the next year, the $11,380 will grow into $12,950.44; $1,570.44 gain. $190.44 more interest than the year before. There it is again, compounding interest.
The most important ingredient for the fullest effect of compounding interest is time. Going back to that $10,000 S&P 500 index, assuming you left the portfolio alone for 10 years (no buying or selling) it would be worth $36,426.93. That’s a capital gain of $26,426.93! That’s a passive income of $2,642.69/year or $220.22/month. But we said that time is the most important ingredient, right? Let’s stretch this out a bit. Let’s say you started that $10k investment portfolio at 18 and never touched it until retirement at 60. For that initial $10,000 investment, you’d be able to retire with $2,280,210.80!
So the only question left is: why haven't you started yet?
There are plenty of online tools for interest calculations. I personally use:
https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator.
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