“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
– Albert Einstein
It can work for you and do amazing things for you. But it also has a dark side.
If you are on the right side of the fence, have little to no debt, and have some
You see, if you are working, you can only make the money you are being paid for. If you are self-employed, you can only make the money for the sale of your goods and services. Either way, there is a limit. You are working for the money, and it is not considered passive.
So, this concept, as simple as it is, can make you thousands, even millions of dollars. You just have to get on the right side of the fence and stay there.
So, let’s dive into this and figure how what compound interest is, how it works and how it can help us.
What Is Compound Interest?
Making money on the money. And then, having that money make money on the money, and so on.
But, if you are in debt, then someone is making money on your money, and I think you know the rest.
So, with compound interest, you’re not just earning interest on your original investment. Your interest becomes your money, it is reinvested and then even your interest earns interest. Compound interest is the process of adding the interest you’ve already earned back into your principal balance, which increases your returns by compounding them.
For example, if you have a $5,000 savings account at a fixed annual rate of 5%, you will earn $250.00 in year one, leaving you with a balance of $250.00. It would actually be more than this if your compounding was monthly, but we are keeping it simple and showing annual compounding for now. So, year one, you now have $5,250 in savings.
Rinse and repeat, but in year two, you make $262.50. So, you now have $5,512.50.
Over 10 years, your balance would grow to $8,144.47. If it was compounded monthly, $8,235.05, and $8,243.32 if daily.
Interest can be compounded annually, semi-annually, monthly, or daily. The more frequently interest is compounded, the more rapidly your principal balance grows.
Compound interest is considered one of the, if not the best way to build wealth. So basic but so effective.
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Simple Interest vs. Compound Interest
Only the principal is used to compute simple interest. The principal is not compounded or increased by the interest earned. You are only paid interest on the original investment.
So, for simple interest, that $5,000 account balance that earns 5% annual interest would pay you $250 a year. The interest earned is not considered part of the investment and does not earn interest.
In other words, the interest is only calculated on the initial $5,000 again the next year, not on the $5,250.
Simple interest is commonly used on debt such as car loans and personal loans. However, interest on credit card debt and lines of credit compounds, so you have to watch your minimum payments and keep that in check.
So, a perfect scenario is to have savings and
How Does Compound Interest Work?
Like a good recipe, there are a few key ingredients when calculating compound interest. Any change to any one of them, can and will affect the end result.
Interest: This is the interest rate you earn or are charged. The higher the interest rate, the more money you earn or the more money you owe. Usually quoted as an annual figure.
Original Investment or Debt Amount: How much was your original investment or how much money did you originally borrow? Compounding is all based on the initial amount you invest or borrow.
Compounding Frequency: How often interest is compounded—daily, monthly, semi-annually, or annually. This factors into how fast the balance grows.
Term: How long do you plan to be in the investment or how long to pay off a loan? The longer you have your funds invested or the longer you it takes you to pay off a debt, the longer it has to compound and the more you’ll earn or owe.
Investment and withdrawals: If you make additional investment during the term, it will affect your amount. How often will you make loan payments and if you make any pre-payments will affect your amount. If you increase your principal balance or pay down your loan during the term, it will have a significant impact.
Investing on Steroids
The power of compound interest cannot be under estimated. If you are on the investment side of things, it is truly a beautiful thing.
Look at this sample
You start with a $50,000 investment
You contribute $500 per month to it
It is at 5 percent
The term is 25 years
Total invested over 25 years is $199,500
Total simple interest earnings – $155,938
Total compound earnings – $115,882
Value of investment – $471,319
What If I Am Not An Investor (yet) But Paying Interest On My Debt?
Well, hopefully the debt you carry is not compounded and if it is, its manageable. Otherwise, it will increase what you owe, whether you are making payments or not.
So, always make a payment enough to at least cover interest and then some and you should be fine. If not, the interest is added to the balance, and you stay in debt longer.
This is where the second part of Einstein’s quote come s in “He who understands it, earns it. He who doesn’t, pays it.”
So, you need to move from paying interest to investing as quickly as possible.
How Can Compound Interest Work For You?
Worst thing you can do is start later thinking you are young and have time. Even if it’s a small amount, start.
With compound interest, time is everything. Every extra month is extra compounding. Every extra dollar you invest each month, is extra compounding. The sooner you start saving or investing, the longer amount of time you give your investment to grow. This is why it’s important to start investing for retirement as sooner rather than later. The earlier you start; the more money you will have earned from interest and the more money you will have earned from compounding. Or rather, much less of your own money that you would have to save. Most of your retirement money can grow with compounding and interest.
Be very mean towards your debt and pay it down as aggressively as possible. Get on the right side of the fence when it comes to compound interest. Even if you have
What Is the Formula for Compound Interest?
Not going to go there. I don’t know anyone that would use the formula in this day an age regardless. I could spell out the Excel formula instead, but even that would not be of value.
Instead, follow the link to a compound interest calculator and input some proforma investment figures. See for yourself how the magic of compounding can work for you.
Last But Not Least – Our Friendly Advice
Compound interest and compounding is investment on steroids. It can really accelerate the value of your
But remember, we also reviewed how compounding may not be your friend. For example, with high-interest credit card debt.
On the other hand, debt can be your motivating factor to kick start your investment future. Attack the debt and get on a monthly savings and investment program. You will be glad you did.
