Are you using the stock (Samsung) keyboard? If so, you need to enable T9 Trace - go to Settings -> Language and input and select the gear symbol to the right of the Samsung keyboard, then be sure T9 Trace is checked.
Edit: BTW, there's also the Swype keyboard, which does what you're describing. You just need to make that the Default keyboard - in the Language and input screen, just select Default and it'll let you pick which one you want to use.
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