It’s been called one of the greatest forces in the universe. Understand it and you’ll see why some people invest their way to wealth, while others quickly become stuck in a quagmire of debt. This simple but powerful force is compound interest. Let’s see how it works and why it can profoundly affect your financial life.
Let’s say you possess $1000 to invest and that you earn 10% each year on your investment.
At the end of the first year you would have earned $100, bringing your total investment to $1100.
But, let’s say you invested a second year. How much would you have accumulated at the end of the second year?
It’s tempting to answer $1200 ($100 earned in year 1, plus $100 earned in year 2), but in reality you would have earned even more. You would earn 10% not just on your original investment of $1000, but also a 10% return on the $100 you made in your first year.
Therefore, at the end of your second year you would have made a 10% return on $1100 (not on $1000), earning you $110 for a total investment of $1210.
This simple concept (the fact that you earn interest not only on your original investment but also on any accumulated interest) helps explain why compound interest can dramatically grow your money.
Let’s further examine how compound interest would make your initial $1000 investment blossom.
$1000 invested with a 10% annual return would grow as follows:
At the end of year 1 you would have: $1100
At the end of year 2 you would have $1210
At the end of year 3 you would have $1331
At the end of year 4 you would have $1464
At the end of year 5 you would have $1611
At the end of year 10 you would have $2,594
At the end of year 20 you would have $6,728
At the end of year 30 you would have $17,449
At the end of year 40 you would have $45,259
But here’s the important point. Compound interest can work just as effectively against you. When you take out debt compound interest makes that debt grow faster. The same $1000 in debt with a 10% annual interest charge would snowball just as quickly (assuming you made no payments or minimal payments). This explains why debt quickly gets many people in trouble.
Albert Einstein is commonly attributed to have said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
When you go into debt, compound interest becomes your greatest enemy. Invest, and compound interest becomes your greatest ally.
BWMK, are you already taking advantage of compound interest?