Wouldn’t it be wonderful if we could all build wealth overnight? Unfortunately, that’s not the way that the world works – but that doesn’t mean you should give up on that wealth. Instead, it’s time to learn about continuous compounding. It’s the secret to building wealth over time.
Continuous compound interest is something we talk to our Addition Financial members about all the time. We want our members to achieve their long-term financial goals, and there’s no denying that continuous compounding is one of the best ways to put your money to work for you. Here’s what you need to know.
What is Continuous Compounding Interest?
When you first learn about compound interest, you are most likely to hear of compounding at regular intervals. There are accounts that compound daily, weekly, monthly, quarterly and annually.
Continuous compound interest happens when interest is compounded, essentially, every moment. Because the figure is approaching an infinite number, it can be difficult to understand unless you’re a calculus whiz.
You should think of continuously compounding interest as a way of putting your money to work for you on a constant and ongoing basis. If you put money into an account with constant compounding interest, the value will be growing every minute of every day.
It’s important to note here that you won’t see much difference between daily compounding and continuous compounding in a single year. For example, the same amount of $10,000 would yield the following balance in these two accounts with the same 5% annual rate:
- $10.512.67 with daily compounding
- $10.512.71 with continuous compounding
The amounts will increase over time and if you can find an account that compounds interest continuously, it is the best way to maximize your earnings.
Start Saving as Soon as Possible
The first piece of advice we have for you about building wealth is to start saving as soon as possible. To illustrate why this is so important, we’re going to look at two people, Lisa and Dan.
Lisa gets a jump-start on her savings by investing $20,000 of her salary every year for 10 years, starting at age 25, in an account with a 7% annual interest rate, she would have close to $280,000 at the end of a ten year period. If she then left that money alone in the same account, neither contributing additional funds nor withdrawing anything, by the time she reached the age of 65, the balance for her retirement account would be 2,282,923.90.
Now let’s look at Dan. He didn’t start investing at a young age. In fact, he waited until he was 40 to start seriously saving for retirement. If he contributed $20,000 every year for the next 25 years, his account balance would be $1,311,330.40 when he reached the age of 65. That’s only 57.44% of what Lisa has saved.
The kicker? Dan contributed $500,000 to his accounts to get to that number. By contrast, Lisa contributed only $200,000. He contributed two and a half times what Lisa did and earned only a little over half of what she did. The sooner you start saving with continuous compound interest, the more money you will have for your retirement – and the less it will cost you to get there.
Leave Your Money Alone
One of the most difficult things for people to understand about compound interest is that time is an essential part of the equation. If you get impatient and move your money around, then you won’t reap the benefits of continuous compounding.
If Lisa took her $280,000 at the end of ten years and put it into investments that earned her a 500% return when she cashed them in at the age of 65, her account balance for her retirement would be $1.4 million. Simply by leaving it alone, she would have earned an additional $800,000 for her retirement savings.
It’s important to note that some investments may allow you to build wealth but the risk is also higher than it would be with continuous compounding. Lisa could get lucky and earn a much higher return than 500% – or, she might earn less.
The best way to look at continuous compounding interest is that it is a slow growth strategy. You won’t get rich overnight – but that shouldn’t be the goal. Get-rich-quick schemes are almost always too good to be true. Continuous compounding interest offers slow and steady growth that becomes significant over time.
Reinvest Your Dividends
Investing in stocks that pay dividends is a popular way to grow your cash flow, but it’s important to do it the right way if you want to maximize your savings and wealth creation.
Sometimes, an investor will take their dividends and cash them out, using the money for regular expenses or a splurge, such as a family vacation. However, if your goal is to build wealth, then your best bet is to reinvest your dividends in an account with continuous compounding.
Some investment accounts give you the option of reinvesting your dividends automatically. We believe that’s the best way to create a continuous growth of wealth because you’ll never see the dividends. They will automatically be rolled back into your investments to earn more money for you.
Maximize Your Contributions
If you look at the example of Lisa and Dan, above, you’ll understand that the more you save early in life, the more you will have when the time comes to retire. It’s for that reason that you should contribute as much as you afford from your earned income to your investment and savings accounts.
The best way to ensure that you’re contributing as much as possible is to create a household budget. Budgeting will ensure that you have the money you need to pay for housing and other necessary expenses while allowing you to make monthly contributions to your savings account.
On a related note, we suggest that if you are living within your budget and you get a raise, you may want to add your increased income to your savings account instead of spending it. The same can be done if you receive an annual bonus.
Supplement Your Compound Savings with Other Accounts
You already know that the best way to build wealth with compound interest is to leave your money where it is and allow it to grow. But what happens if you need money immediately? The solution is to supplement the continuous growth of your compounded interest with other investments that you can use if you need them.
For example, you might decide to put some money into a mutual fund that can potentially earn a high return. If you need to withdraw money, you’ll have access to it when you need it and you won’t need to dip into your retirement savings. A certificate of deposit (CD) or term share certificate might also be a good option. A long-term CD will generally have a higher annual interest rate than you might find elsewhere but your money will be unavailable to you until the period of the CD is over.
On a related note, we love the idea of using a money market account with compounding interest to create an emergency fund. It’s a good rule of thumb to have between six and 12 months’ worth of expenses saved in the event that you lose your primary source of income or your family has a medical emergency.
The best part about using a money market account to create your emergency fund is that compounding interest will allow you to reach your savings goal as quickly as possible. The money will be liquid, so you can use it if you need it. But if you don’t need it, leaving it alone will allow the value to grow and add to your wealth over time.
Pay Attention to Fees and Commissions
You now understand the power of continuous compounding but there’s one more thing that can significantly impact what you earn: investment fees and commissions.
When you choose an account to build wealth, make sure that you read the fine print and understand every fee and commission that you’ll be paying as you grow your cash flow. Any fee that is calculated as a percentage of your wealth is something you should scrutinize because a too-high fee can impact your ability to earn money on your interest.
When it comes to investing, there’s plenty of evidence to suggest that passive investments perform better than active investments. That said, if you decide to use a robo advisor, make sure you understand the fee structure and how it works.
You should also be wary of financial institutions that offer so-called teaser rates to attract new clients. Sometimes, banks advertise a high compound interest rate that then changes after a few months. Some interest rate changes are unavoidable but beware of any financial institution that uses “bait and switch” techniques that can impact your wealth creation.
The power of continuous compounding interest is undeniable. By making your initial investment early and allowing your money to grow, you can easily accumulate all the money you need for a comfortable retirement.
Are you looking for a low-risk way to grow your money? Click here to learn about Addition Financial’s Insured Money Market Accounts!
Posted on Aug 24, 2021
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