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Compound interest: The reason we invest

Posted on: December 14, 2011 | Author: Staff

With all the literature and media coverage of investing we see around us, it’s easy to lose sight of the reason we invest in the first place. Put simply, we invest so that the same money we have today will provide us with more money sometime in the future. Whether we’re saving for a down payment on a home, paying for a child’s education, or providing an income for ourselves in retirement, we put money away today in order for that money to grow and provide an even greater benefit for us in the future.

The most basic way our money grows is by generating interest. There are other ways that investments can grow, and we’ll talk about those in upcoming articles.

When our investment pays interest, it grows. When our investment pays interest on the original investment plus the previous interest it’s called compounding, or compound interest. Compounding is very powerful in investing.

Below we compare two investments of $1,000 at a return of 10 per cent per year. One pays interest on just the original investment and the other pays compounded interest:

compound_interest.png

There is a great advantage to getting interest paid on your interest. It does take patience, however. The longer you allow your investments to compound, the more you benefit.

If you've ever had a large loan such as a mortgage, you’ve seen this work the other way. At the beginning of a mortgage, when the principal is large, interest paid to the bank amounts to the majority of your payment. But as the principal gets paid down, interest becomes a smaller part of the payment.

Compounding puts you in control. With some patience and discipline, you can be the one getting paid interest.

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