Compound Interest - the most powerful force in the universe

Financial Freedom

 

What is compound interest?

When you invest your money and receive interest (free money) it is added to your investment, giving you a new total. The next time you receive interest, it is calculated based on your new total including the free money from last time. This happens over and over, and after several years, your initial investment will grow tremendously. 

In other words, it's the principle by which the interest you earn also earns interest, and the interest on that interest earns interest. The larger your balance gets, the bigger those interest numbers become.

There are 3 main factors involved here:

  1. Principal (how much money you start with)

  2. Interest rate (3%, 5%, 10% etc...)

  3. Time (1 year, 10 years, 50 years etc…)

Want more - check out this video by Investopedia.com:

Source: Investopedia.com

Needless to say, compound interest is very different than simple interest in terms of making you money. Check the examples below:

 

Example: Simple Interest

You have $100 in the bank and your interest rate is 5% per year.

Year 1: $100 + $5 = $105 ($5 in interest)

Year 2: $105 + $5 = $110 ($5 in interest)

Year 3: $110 + $5 = $115 ($5 in interest)

 

Example: Compound Interest

You have $100 in the bank and your interest rate is 5% per year compounded annually.

Year 1: $100 + 5% = $105 ($5 in interest)

Year 2: $105 + 5% = $110.25 ($5.25 in interest)

Year 3: $110.25 + 5% = $115.76 ($5.51 in interest)

 

What’s good?

Clearly you make a lot of money over time, much more than with simple interest. If you want to see how much money you can make over a certain period of time you can grab a calculator. Except you’re going to want to use a compound interest calculator to make things simple:

Like this one from: Moneychimp.com

I encourage you to play around with it.

If you want to do the calculation in your head here’s a trick - it’s called the Rule of 72. The rule says that to find the number of years required to double your money at any given interest rate, you can simply divide the interest rate into 72.

E.g. In order to double your money at 8% interest, divide 8 into 72 and get 9 years. (72/8 = 9 )

This is a powerful tool to start planning your financial independence. The visual below demonstrates how quickly your money can grow using the power of compound interest.

You basically want to maximize this effect whenever and wherever possible.

FINRA-Graphic-Showing-Compound-Interest.png

 

What’s bad?

Compound interest really is all sunshine and rainbows - it will magically grow your money at an increasing rate as years go on. But you should know, life really depends on what side of the curve you are on. If you took the same graphic above and flipped it upside down, you would see another type of curve. This is more like the one representative of how you pay off a mortgage on your home, credit card, or loan.

Take this credit card debt payment for instance, at a typical interest rate of 19%-20%:

Example

Year 1: $5,000 + 20% interest = $6,000 ($1,000 was interest)

Year 2: $6,000 + 20% interest = $7,200 ($1,200 was interest)

Year 3: $7,200 + 20% interest = $8,640 ($3,640 was interest)

Within three years, the amount of money owed to the credit card company is almost double the original balance. Compounding interest sucks when you owe money. (Be on the right side of the curve!)

 

For a significant number of years, your mortgage payment is mostly going to pay the interest to the bank. It's only in the later years that your payments actually pay off the principal loan. This is how the bank makes money - they know about compound interest.

These curves appear in a lot of aspects of life. Someone's always on the right side, and someone's unfortunately always on the wrong side. Now that you are aware, make a conscious effort to see the pay or earning structure of the deal and make sure you're on the right side of it.


If you're looking for more information, these 2 books are great resources. A lot of the concepts I talked about in this post originate from these books.

 

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