Hey all, let’s talk about the eighth wonder of the world! I’m, of course, talking about compound interest. In personal finance, this concept is an amazing way of how money grows from itself and in this post, I'm going to talk about how compound interest works.
With Compound interest, if you had $100 and your $100 grew 1% a day, you would have $3,778 after a year. That’s because, with compound interest, your money earns money, and that money earns money on itself, and so on, and so on.
You can create passive income streams that will last you a lifetime. Let’s jump right in!
What Is Compound Interest
Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” How right he was! Some say it is the most powerful force in the universe.
Investopedia defines compound interest as “interest calculated on the initial principal, which also includes all of the accumulated interest from previous periods on a deposit or loan.”
What this means, in short, is that compound interest is earned on a balance, it’s calculated based on the original balance plus any previous interest earned.
How Compound Interest Works
Alright, let’s break that down into simpler terms. Let’s assume you started investing $100, and you earned $8 in interest over one year (your rate of return is 8% annual interest).
Now you have $100 from your original balance and $8 in earned interest. Your next year, you also earn 8% of compound interest. So instead of earning another $8 on your $100, you earn $8.64 on your $108, which is 8% of $108.
What happened was, you earned interest on your original $100 plus on your total interest.
Now you have $116.64, and let’s assume you earn yet another 8% the following year. Any idea what you’ll have? Using a calculator you can see 8% of $116.64 is $9.33, so $116.64 + $9.33 is $125.97.
What does compound interest mean in the long term? Next, I’ll talk about how compound interest will make you rich.
How Compound Interest Will Make You Rich
The power of compound interest is really quite incredible. Let’s take the example of investing. Assume you can afford to invest in the stock market, weekly into a typical S&P 500 index fund.
Historically speaking, you would see an average of a 9% return on investment year after year. For this example, we’ll assume that’s the case.
Below, I’ve created an infographic of how much money you’d have over various periods of time for a $25/week investment, a $50/week investment, and a $100/week investment to demonstrate how compound interest works.
Looking at the above, you can see how much of an incline the $100/week increases to as the years go on when compared to $50/week or $25/week.
In fact, at $100/week, in the five years between year 25 and year 30, you will obtain over 25% more money than all 30 years combined at $25/week. That’s amazing!
Another way to look at it: If you invest $100/week each week, you will take just over 10 years to get your first $100,000. It will then take less than 6 years to get to a total of $200,000, and each $100,000 beyond that will be quicker and quicker.
The reason is that your $100 per week from your earlier years is creating a significant push on your money for the later years. So, as you can see in the picture, the curve is concave up, meaning your money is growing more rapidly as time passes.
This shows how your money grows on itself and is a perfect example of how the rich get richer using the power of compound interest.
Why is Compound Interest Preferable to Simple Interest?
Why is compound interest preferable to simple interest? Simple interest is different than compound interest in that the interest doesn’t grow on itself. Simple interest is only calculated on the initial principal. In basic terms, here’s an example:
If you were to deposit $10,000 into an account that earned 4% APY and the interest was calculated with simple interest versus compound interest, here’s what your growth would look like over 10 years.
$10,000 growing at 4% simple interest per year will be worth $14,000 after 10 years whereas $10,000 growing at 4% compound interest will be worth $14,802.44 – a difference of $802.44. This makes compound interest preferable to simple interest.
As time passes, compound interest gains traction over simple interest, starting at a mere 0.15% difference in year 2 to a 5.42% difference in year 10. It will continue to grow as the years go on.
This is why when you are paid interest, such as with storing your money with a bank, you'd want an account that pays compound interest versus simple interest.
Compound Interest Calculator
If you’d like to play around with numbers yourself, here’s Bankrate’s compound interest calculator. You can visualize exactly how your money will grow over time via compound interest.
Below is a screenshot of how to use Bankrate's compound interest calculator.
In the above example of this compound interest calculator, I've added a starting amount of $10,000 with 10 years of savings at a 4% return on investment. Additionally, I've said that I'll save $50 per week and that the interest will be compounded daily. After 10 years at this rate, I would have $46,898.
Investing early on is so important because when you invest, your money compounds in a similar fashion. That is, your money grows on itself and not just on what you’ve invested initially.
Wrapping It Up
Compound interest is truly the eighth wonder of the world, and when you harness, you will earn more money at increasing rates as time goes on. Whether you can afford to invest $50 a month or $500 a month, taking advantage of compound interest early on is crucial.