“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who does not understand, pays it.”
Albert Einstein is believed to have said this. There are a lot of quotes attributed to him that he didn’t actually say, and this may be one of them; I personally don’t see the guy who imagined riding a light beam to understand the theory of relativity waxing poetic about compound interest.
But even if Einstein didn’t actually say that compound interest is the eighth wonder of the world, it’s still a good thing. compound interest Is very nice. It’s a powerful concept – one that can strengthen or weaken your finances in a big way. This can either work against you (when it comes to loans) or for you (when it comes to savings and investments). The person who understands this will have a tool to increase his net worth; A person who does not do this will spend his life trapped in a salary mentality.
Unfortunately, not every young adult has someone to sit them down and explain to them about compound interest. Which is a shame, because the sooner you put it to work, its power increases greatly. If you want to prepare a young person for financial security and wealth, deliver this accessible and inspiring primer to them. If you’re older and have never studied compound interest, or you could use a refresher on it, this guide is for you too. Even if you’re a late starter to taking advantage of compound interest, the second best time to plant a tree is now, as they say.
What is compound interest?
To understand compound interest, it is useful to first understand simple interest.
Simple interest is calculated on the principal amount or principal amount of the deposit or loan. It’s really easy to figure out.
Let’s say you take a loan of $10,000 at a simple interest rate of 5%. The loan tenure is four years.
To calculate the interest that will accrue on the loan, you will use the following formula:
Principal x Interest Rate x Loan Period
Adding our numbers will result in:
$10,000 x .05 x 4 = $2,000
So that $10,000 loan will cost you $2,000 in simple interest.
Car loans and student loans use simple interest. A loan you take out from a family member or friend will likely use simple interest (if they charge you interest at all).
Now that you understand simple interest, we can move on to compound interest.
Compound interest is calculated on the principal amount and – this is important – also on the accumulated interest from previous periods. This is interest on interest.
The compound interest formula looks like this:
P(1 + r/n)^(nt) − P
(P = Principal; R = Annual interest rate in percentage terms; N = Number of compounding periods in a year; T = Number of years invested or borrowed)
Yes, it sounds confusing, but let’s plug in our numbers from the simple interest example to see how much we would pay if the interest was compounded.
So we got a $10,000 loan that got mixed up every year At 5%. The loan tenure is 4 years. What will we pay in interest? Let’s look at the progress of mathematics:
$10,000 (1 + .05/1)^(1×4) – $10,000 →
$10,000 (1.05)^4 − $10,000 →
$10,000 (1.21550625) – $10,000 →
$12,155.0625 – $10,000 = $2,155.06
So on a four-year loan, compounded annually, we would pay $2,155.06 in compound interest. This is $155.06 more than the loan issued at simple interest. Calculating interest on interest already earned on the principal can actually add up. add more Fast As we will see in an example below.
If you don’t want to do the math yourself, there are plenty of compound interest calculator Online.
Credit cards charge compound interest, and unlike our example above, they usually compound it daily rather than annually. The high interest rates on credit cards, along with their compounding daily, is why almost every personal finance guru says, “Don’t carry any balance on your credit cards!” You pay too much for that extended credit. For example, a credit card balance of $10,000 at an interest rate of 20% (compounded daily) would have a total of $2,213.36 compounded interest over a year, or about $184 per month.
However, compound interest can work in your favor. big time. When you deposit your money in a savings account, banks usually pay interest compounded daily on the money you keep. The national average savings interest rate is 0.61%, and some of the top high-yield accounts are around 4%. Put $10,000 in an account paying 4% interest compounded daily, and you’ll earn $408.08 in a year without lifting a finger. It connects.
If you invest in an index fund, you can take advantage of the power of compound interest by investing your earnings into buying more index funds, which will allow you to earn even more, which you will then reinvest, and so on.
Compounding period has a big impact on earnings
Looking at the compound interest formula, you’ll probably notice that the frequency of the compounding periods can have a big impact on your earnings or how much you’ll pay in interest. The longer the compounding period, the more interest earned. You’ll earn more interest from a bank that compounds daily than from a bank that only compounds monthly; You will pay more in interest on a loan that is compounded monthly compared to interest that is compounded annually.
So when looking at interest rates for a savings account or loan, be sure to pay attention to how often the interest is compounded.
time is your friend
The real magic of compounding comes in the long run. The longer you let your money stay in the account and compound itself, the more money you’ll make.
This example from personal finance expert Beth Kobliner makes the point:
If you were to save $1,000 a year from ages 25 to 34 in a retirement account earning 8% per year, and never invest a penny more, your $10,000 investment would grow to $157,435 by age 65. But if you don’t start saving until age 35 and then invest $1,000 per year for the next 30 years (that’s a total investment of $30,000), by age 65 you’ll only have $122,346. The bottom line: Start early, so your money has plenty of time to accumulate.
The way investments grow over time means that how you decide to make big purchases can have a much bigger impact on your finances than you even realize. For example, let’s say you choose to buy a $600,000 home instead of a million dollar home, and you only have to make a down payment of $100,000 instead of $200,000. You then invest that $100k saved and earn an average 10% annual return on it. In 30 years, that $100k will turn into almost $2 million dollars. Over 35 years, this could net you a profit of almost $3 million. So in choosing a more affordable home, it’s like you made yourself $3 million dollars. (And that’s not even counting the money you’ll save on your monthly mortgage payment and the interest you pay on that loan.)
But the snowball effect can also have a profound impact when it comes to investing small savings. If you can find a way to save $10 a day, for example, by bagging your lunch instead of eating out, and you invest that money in the market, then in 30 years, it will turn into $700k. In 40 years, you will have approximately $2 million. Note both how small savings can add up and what a difference a decade makes!
The bottom line: The sooner you invest, the better off you will be. Get your kids started now! Even if you’re older, investing today instead of now will make a significant difference even five years from now.
Use the power of compound interest to your advantage
Understanding compound interest can really help you get ahead with your finances. Knowing that credit card companies accrue interest on your balance on a daily basis should act as an incentive to pay off credit card debt as quickly as possible. Knowing that you can make money with your money should encourage you to mop up as much dough as possible and not touch it for as long as you can.
The main thing is to start today. If you have credit card debt, start paying it off now so that the compound interest doesn’t swallow you up. If you don’t have a savings or retirement account, start one today so you can harness the power of this eighth wonder of the world.
Be sure to listen to my podcast with David Bach on how compound interest can make you a millionaire:
With over 4,000 articles now in our archive, we’ve decided to republish a classic piece every Sunday to help our new readers discover some of the best, timeless gems of the past. This article was originally published in July 2018.
