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Using Compounding To Build Wealth

There are several ways to earn income on investments, but compounding may be your most reliable path to wealth. If you put $1,000 under your mattress, it will still be $1,000 a year later, but it probably will buy you a little less due to inflation. If you lend the money to a friend at 12% simple interest, at the end of the year you'll receive $1,000 plus $120 of interest, since simple interest computed only on the principal.

Compound interest is computed on both the principal and the interest earned. If you invest the $1,000 in a bond that earns 12% interest compounded monthly, in the first month it will earn 1% (1/12 of 12%), or $10. Now you have $1,010, which will earn 1% interest in the following month, only now the earnings will be $10.10.

At the end of the third month, you'll earn 1% interest on $1,020.10 ($1,000 plus $10 plus $10.10), and so on. By the end of the year, you'll have $1,126.83, or $6.83 more than you would earn if you loaned out the money at the same rate but at simple interest.

A matter of time
An additional $6.83 doesn't sound like much, but things change over time. After 10 years at 12% simple interest, your $1,000 would be worth $2,200, which is the original $1,000 plus 12% or $120, multiplied by 10 years. At 12% interest compounded monthly for 10 years, your $1,000 would be worth $3,300, or half again as much as it would without monthly compounding. After 30 years, you $1,000 would be worth $35,950!

Rate of return
Since after 10 years your $1,000 would be worth $3,300 at 12% interest compounded monthly, it would have earned $2,300. At 6%, after 10 years the $1,000 would be worth $1,819, earning only $819 rather than $2,300.

Now suppose the $1,000 came from your net wages. If you're in a 25% income tax bracket, you earned $1,333 to get $1,000 after taxes were withheld. But what if you could have invested the entire $1,333 for 10 years? Then you will have an additional $1,100.

Compound benefits
The above examples suggest the following ways to use compounding to increase your earnings:
Start saving and investing now. Time is your most powerful multiplier.
Shop for the best rates of return, consistent with your risk tolerance.
Set up your investments to automatically reinvest interest and dividends earned.
Use tax-deferred programs like IRAs and 401(k) plans to the fullest possible extent.

If you want to learn more about compounding, just give us a call. We'll be happy to review the numbers that apply to your business and investment decisions.



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