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If you have done anything with investing then you’ve probably heard about compound interest. Supposedly, Albert Einstein called compound interest “the strongest force in the universe”. But why is this thing that sounds so dry and boring, talked about so much? Just like with the basics of investing, I want to give you the basics of compound interest to help you understand why it is a powerful tool and what you need to look out for.
What is Compound Interest?
To understand compound interest we need to understand the different pieces of it. As I’ve said before, interest is “Money returned on top of the original amount of money invested. For a very simplified example, if I invest $1,000 at a 10% interest rate then I can expect to receive $1,100 back.” So the whole point of investing then is to get interest.
The example from the definition of interest, however, is not an example of compound interest. That is an example of simple interest. Simple interest is a one time payment of the interest percentage on the original principal. So as stated above if I invest a principal of $1,000 at a 10% interest rate, then I’ll get $100 back. Seems pretty simple right?
Get it…simple?… never mind.
I know what you’re thinking, this is all very interesting (okay I’ll stop the puns), but what does it have to do with sliced bread? Well, if you’ve ever made bread before, interest is like adding yeast to your dough. When you add yeast the dough starts to grow and expand and will be bigger than it was when you started. That’s simple interest.
Compound interest, on the other hand, lets you get interest on your interest. Let’s look at this same example. You invest $1,000 at 10% so you get $100 in interest. But that money stays invested, so the next time you get paid interest it is 10% of $1,100 (your original $1,000 plus your $100 in interest). That would be $110 in interest. So now you have $1,210 invested, and so on.
Okay, back to bread. Have you ever seen a sourdough starter? Basically, you make your dough in such a way that the yeast is growing in it constantly. Every couple of days you take take off a piece and make bread, but you still have just as much dough as when you started a few days ago. Now imagine if you never took off a piece of the dough, what do you think would happen? The growth would be incredible.
Okay, not everyone is a baker, so maybe this graph will help you understand how amazing compound interest is.
Keeping with our $1,000 investment, let’s look at the difference between simple and compound interest over 30 years. If you look at the first graph for Simple Interest, (remember I’m a teacher, so if it sounds like you’re in school that is why) you will see that your $1,000 grows to $4,000 over the course of 30 years. But if you look at the second graph with Compound Interest that same $1,000 grows to nearly $20,000! That’s a $16,000 dollar difference!
I’m getting a little too nerdy here. The point is, compound interest is what you need if you want to grow your money long term.
What to Look Out for with Compound Interest
There are a couple of other things to look out for with compound interest. First, while any type of compound interest is better than simple interest, not all compound interest is equal. The important question to ask when investing with compound interest is: When does this compound? or When will the interest I have received be added into to my original principal?
This is where the math gets a little more difficult, so I won’t try to explain it. All of the examples we’ve been looking at have assumed that the interest compounds every year. But what if your interest actually compounds every month? With that same original $1,000 you would end up with $1,104.71 at the end of the year instead of $1,100. You made an extra $4.71.
I know what you’re thinking. It is 4 bucks…big deal.
But here is where the magic happens.
Remember that over 30 years your $1,000 would be nearly $20,000. If your interest compounds monthly you end up with nearly $2,000 more! And that is significant.
The last thing to look out for when dealing with compound interest is that it can work against you. For example, let’s say you have a 5% interest rate on your home. You may think to yourself, I pay an extra 5% of the principal on my mortgage every year. NOT TRUE! It actually compounds monthly, so a 5% interest rate could actually be somewhere around 5.125% over the course of a year.
That brings us to another alleged quote from Albert Einstein, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
So next time you are investing (or getting a loan) make sure you know if it is compound or simple interest, and find out how often it compounds. It will be worth it in the long run.
If you want to learn more about the amazing potential of compound interest, check out the book “The Automatic Millionaire” by David Bach (affiliate link).
What other simple examples help us understand how compound interest works? What other things should people look out for with compound interest? Tell me about it in the comments below.
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Investing: Giving an entity (or an individual) money whether in the form of stocks, bonds, or buying any other type of asset in hopes of getting more money back in the form of interest.
Simple Interest: A one time payment of the interest percentage on the original amount that is lent. A 10% simple interest on $1,000 would be $100.
Principal (investing): The original amount that you invest to receive interest on.
Compound Interest: When interest builds upon interest over time. So a 10% compound interest rate would start with $1,000 becoming $1,100, like simple interest, but then it continues and $1,100 becomes $1,210 and so on.