Compound interest. Defined by Albert Einstein as the 8th wonder of the world, a concept that is so simple and so powerful that when applied to money is the real game-changer.
While I’m sure you’ve already heard about compound interest (or compounding), when you really internalize what it means your perception of the whole thing makes a quantum leap.
I promise you that if you take the time to read to the end, it will be clear why you should make compound interest work for you and what you can actually do to take advantage of the incredible results it can generate for yourself and your financial future.
What Is Compound Interest?
Compound interest (or compounding interest) is exponential growth.
When talking about money, compound interest is the process by which money generates money because you can earn additional interests on the interests.
It’s an incredibly powerful mechanism that can make you or break you.
Let’s see how it works so that you can avoid its negative effects (many concerning debt interests, or investment costs) and take advantage of the immense power of compound interest to grow your wealth and assure your financial future.
Compound Interest Definition
Definitions are always useful to understand concepts, therefore, here’s how compound interest is defined on Wikipedia:
Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest.
It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest.
Perhaps the following example will make things even clearer.
How Compound Interest Works
Suppose you put $100 into an investment that produces you a 10% return every year. How much have you made at the end of year two?
In the first year, your investment grows to $110. In the second year, however, your investment grows to $121 (yielding 10% on $110). In other words, compound interest is the process that makes 10+10=21 instead of 20 at the end of year two.
If your money is invested at a 10% annual return, after the second year your investment produces a total return of 21%.
That’s for two years. But what about 10 years, or maybe 20?
You can clearly imagine what the results would be over 10 years from now or 20 years from now…
…or maybe not?
Let’s play this game.
Suppose that today you take $10,000 out of your bank account and lend it to Modern Times Investors.
I promise you that I will give you a 10% annual interest on the money you lent me until you ask to be paid back.
Time goes on and when we meet in the future you ask to be paid back. Since I’ll keep my promise, here’s the question:
- How much money do I owe you 10 years from now?
- If you waited longer, how much do I owe you after 20 years?
What’s the dollar amount?
If you are still speechless or confused, don’t feel embarrassed.
The idea behind compounding is really simple, but we (humans) have some cognitive difficulties in appraising the results of exponential growth because we are somehow bound to think linearly, not exponentially.
(I will give you the answer in the following paragraph)
The Compound Interest Formula
Understanding the simple math behind this mechanism will let you discover how much your money can grow using the power of compound interest.
It is definitely not rocket science, in fact, it just requires some basic mathematical operators. The compound interest formula is A = P(1+r/n)^nt
- A = the final amount of capital you get after t periods elapsed
- P = the principal, the money you invested in the first place
- r = the interest rate for the period t
- n = the number of times the interest is applied during the period t
- t = the number of time periods elapsed
This is the general formula that can be applied to any amount invested and for every period of compounding.
If you compound once a year, the formula becomes even easier because n=1 and the money you have after t years is A = P (1+r)^t.
Enough with mathematics. From now to the end of the post you will no longer see a formula.
Ok, this is the formula, but how much does money grow over time if you let compound interest do its job?
Growth Of Compound Interest Over Time
This is perhaps the most interesting part of the article, surely the one we care about the most.
How much my money grows if I take advantage of compound interest?
Here’s the answer. Take the $10,000 invested with me at a 10% annual interest rate and run the formula, these are the results:
After 10 years, I owe you $25,937 (2.59 times your principal).
After 20 years, I owe you $67,275 (6.72 times your principal).
I hope I got your attention. By now I guess you are able to estimate what’s going to happen if you let compound interest work.
After 30 years…
$10,000 invested at 10% become $174,494.
While after 40 years…
$10,000 invested at 10% grew into the surprising amount of $452,593.
You might be wondering…40 years is a very long period of time, I don’t know what I’m going to do and what could happen.
You are right, but please consider this. In the majority of developed countries, the average life expectancy is above 80 years and given the enormous advancement in medicine and health care, we have all the good reasons to think it’s going to increase even further.
Now back to you. If you are anywhere before 50 years and have good health, just based on the numbers you can reasonably expect to live other 30+ years. Although 30 or 40 years sound like a long period of time, I would give it a try. If you are in your 20s or 30s… even better!
To quickly recap, this is how $10,000 invested at a 10% annual interest rate (left invested+reinvestment of the interest, compounded at the end of each year) become…
Not bad for being patient!
The following table that shows the evolution over the years.
The idea is simple: the end balance of the previous year becomes the initial balance of the following year. Each year interests are calculated on a total capital that is bigger due to this addition.
That’s why interests generate interest and in the end, produce this huge growth (exponential).
If you are still wondering…
Compound interest is how wealth is created through investing.
If you can make it work for you, which we are going to cover in the next chapters, your financial future is assured.
Compound Interest Calculator – Free Download
The formula of compound interest is a very easy and powerful one and playing around with numbers is extremely useful to internalize this concept and start to think for the long-term.
Would you like to try out the calculation with different capital, interest rate, and time horizon? (highly recommended 😉 )
Here you can download for free a complete compound interest calculator spreadsheet that will allow you to do just that.
It’s the one that I used to make the examples above and that you can use to see by yourself the impact of the different variables on the end result of compound interest.
Not only, but this excel file also allows you to simulate some of the more advanced stuff like annual or monthly contributions, compounding at the beginning or at the end of the period, and the long-term effect of taking out a portion of the interest as a payout.
Still waiting? Grab the compound interest calculator spreadsheet here and play around. It doesn’t cost you a dime but making this concept yours can earn you a fortune.
Once you’ve got the calculator, let’s see what you can actually do in order to start earning compound interest and make things work for you, and avoid the trap of paying it.
Why Is Compound Interest Important?
Compounding is the process of growing, exponential growth. It is the “snowball effect”, a self-growing process that builds upon itself.
Compounding happens when interest is paid repeatedly, whether you earn it or you pay it.
And this is exactly the reason why is so powerful when applied to investments and so dangerous when applied to debt or commissions.
Although the first couple of cycles are not especially impressive, once exponential growth starts to pick up the interest adds over and over again and explodes.
This is why with time and consistency one can build a fortune. This is why people that pay debt with other debt are doomed.
Getting out of debt is a really good idea for your financial future because I guess that now you’ve seen and hopefully understood the direction you are heading to if you keep paying interest on interest.
Also, a positive saving rate and a consistent and regular plan of investments can lead to extraordinary results over time (hint: if you find investing extremely boring, that means that you are on the right track to success).
The following are the elements that you can leverage in order to take advantage of the power of compound interest.
How To Take Advantage of Compound Interest
I’m sure that you noticed that there are five key elements involved in the process of compounding. In order to make the maximum out of this mechanism, one should work on each and every one of them.
The five critical variables of compound interest are:
- Time – The longer, the better. Go back to the charts and you can clearly see how you need time in order to have exponential growth. The amount of interest ultimately skyrockets but only after some years.
- Interest Rate – this variable is critical, perhaps the most important, and determines the speed at which the amount increases. Needless to say, the higher it is, the faster compounding works (and the better for you if you are earning it! The opposite if you have to pay it).
- Frequency of Compounding – in the examples, money was compounded once every year at the end of each year. The frequency of compounding matters a lot. The more frequent compounding periods are, the bigger the results will be. A monthly or daily compounding results in faster growth.
- Deposits and Withdrawals – adding money over time improves the whole strategy because those deposits start to generate interest and this interest will generate further interest over time. On the other hand, if you are taking money out, you literally dampen the effect of compound interest because you don’t allow for the growth to take place.
- Initial Capital – even though compound interest works in the same way whether you start with $1 or $1 million, the amount of money you start with can have a huge difference for you. The bigger the initial capital, the bigger the initial interest. If your goal is a specific amount of money, dedicating a nice chunk of your money to the project certainly helps.
4 Practical Ways To Make Compound Interest Work For You
Like many other things in life, the most important thing is to get started. In the case of compound interest, the earlier the better. As the Rolling Stones would say, time is on your side.
Given how powerful compound interest is, when planning your personal finances you should definitely think about how to make it work for you.
Here are four things you can do:
- Start Early – if you want to earn money and create wealth taking advantage of compound interest WHEN you start is far more important than how much you save. Starting early allows exponential growth to outweigh how much you save.
- Check Your Yearly Rate of Return – different assets generate different rates of return. Compound interest always works, but you need to invest the money in order to have a return. The options here are endless and range from saving accounts to stocks (See the next paragraph on compound interest investments).
- Contribute Often – by making additional contributions to your investment project over the years, you speed up the growth and increase the amount of money that is working for you. If the most important thing is to get started, the second most important thing is to keep going. Creating wealth is a process and adding money over time is a variable that you control.
- Discipline – If you plant the seed of a tree and want to eat the fruits (an experience that I did and I honestly recommend to you) you have to wait. There are no alternatives. Furthermore, the longer you leave your money untouched, the greater it can grow.
This point is where most of us fail when it comes to investing: switching back and forth from one investing opportunity to another is detrimental to your financial success.
If you set everything right, you just have to wait. This is also good news because it means that you can go out to live your life instead of worrying about your finances.
Compound Interest Investments
There is not a label that says “this is a compound interest investment” and that other one is not. Any investment can potentially be a compound interest investment, it all depends if you reinvest the proceeds.
The mechanism of compounding works if what you earn is reinvested, be it interests, dividends or capital gains.
Investments can be short-term or long-term and should always depend upon your overall situation, tolerance for risk and time horizon. Different investments offer different levels of return, the followings are among the most popular options to put your money to work:
- Certificates of Deposit – they are issued by banks and generally offer higher interests than traditional saving accounts and pay interest at regular intervals
- Saving Accounts – preferably high-interest saving accounts, they pay interest on the account balance and they are more suitable if you need the cash quickly
- Bonds – both government and corporate bonds, they offer various interest and various maturities as well as different level of risks. They are also called fixed-income investments due to the fact that if you hold them to maturity and the issuer pays you back, you know the amount of interest you are going to generate
- Stocks – shares of real companies that generally offer higher growth and provide cash by distributing dividends
- REITs – real estate investment trusts are companies that own and operate real estate investments, some of them are publicly traded and it’s a great option to invest in real estate without managing the property
It all depends on your goal, your temperament, and your financial situation. Also, it’s good to have different amounts of money allocated into different investment vehicles for specific purposes.
For example, keeping a sum that covers 6-12 months of living expenses in redeemable CDs or saving accounts.
If you have planned expenses 2-5 years from now, park the money in bonds with a matching maturity.
If you are planning to send your kids to college in 20 years or you are investing for retirement, taking a little more risk in order to have a higher growth of your capital over the years is a sensible thing to do. In this case, it would be better to invest in a market portfolio of stocks and bonds, held preferably through a broad market index fund.
2 Books That You Will Find Interesting…
… and that will help you enormously to compound your money over time.
Even though we live in a digital world, at the end of the day books are still one of the best ways to learn and acquire real knowledge (without distractions).
While I think that any book on money sooner or later mentions the concept of compound interest, as additional reading for this article I would like to recommend you two easily readable books:
It takes less than a week to read both books and after reading them it will be clear how anyone in any job or industry can reach important financial goals without becoming mad about investing or making huge sacrifices.
If you make your money work for you and successfully take advantage of compound interest you can literally build a fortune. This is not an overstatement.
Compound interest is exponential growth, it’s money that generates money, generating proceeds also on the money that was previously earned as interests, dividends or capital gains.
Compounding is a process of growing and in order to have it, there must be the reinvestment of the money earned.
We don’t naturally grasp the final outcome of exponential growth because we are bound to think in a linear manner, that’s why playing around with numbers and make some simulation is incredibly helpful.
Compound interest is so powerful when applied to the money you earn and so dangerous when applied to the money you owe.
- Getting out of debt
- Having a positive saving rate
- And investing regularly a nice chunk of what you earn
Is how anyone can build wealth.
The sooner you start, the better. For growth to happen it takes time but the results are extremely rewarding.
Your investments should always match your financial situation, your goals, and your risk profile. There is not “THE” right investment strategy, but there surely is the right investment strategy for you.