Compound interest is one of the most important topics to understand in all of personal finance. It is the basis for investing and the way in which most millionaires become millionaires. Do you want your investments to grow exponentially? Well then you might want to start by understanding this topic. Let me help you
What is Compound Interest?
Compound interest is the way in which your money grows at an exponential rate.
It is the interest that is calculated on BOTH the principal and the previously accrued interest. This is the largest differentiator between compound interest and simple interest. Simple interest only accrues interest on the original principal balance.
In fact, there is a specific calculation to figure out compound interest. (Although, there are several online calculators that are easier to use.) Here is the calculation:
A = P[1 + (r/n)]nt
A = Final Amount
P = Principal Amount
r = Interest rate
n = Number of times the interest applied per time period
t = Number of time periods
Like I said, you don’t have to memorize this formula unless you are a math nerd or something. But just know that there is a specific formula for compound interest.
Why is Compound Interest Important?
Compound interest is important because it is the basis for investments. When you earn interest on your investments, it pays out on the principle that you invested AND the interest that it accrued before.
Let me give you pretty basic example:
Dan invests $1,000 into an ETF that earns 8% every year.
After one year, his investment has grown by 8%. That means that he has $1,080 at the end of the year.
When the next year starts he has $1,080. It also grows by 8%. At the end of the second year he had $1,166.40.
When the third year starts, he has $1,166.40. It too grows by 8%. Now at the end of the third year, he has $1,259.71.
So after one year, he earned $80.00 in interest.
After the second year he earned $86.40 in interest.
And after the third year, he earned $93.31 in interest.
If he were to invest for a fourth year the interest that he would earn would be even more than the third year and so on and so on.
Here’s a chard at what Dan’s investment would look like after 10 years:
If you ever hear of someone talking about an investment “hockey stick”, this is what they are talking about.
Compound interest doesn’t let an investment grow in a linear fashion. It grows in an exponential fashion.
This is also how you can accumulate LARGE amounts of money in your retirement accounts.
Final Thoughts
Compound interest is the bread and butter of investing. It’s kind of like pushing a snowball down a hill. It might not go very fast or accumulate very much snow at first. But over time the original snowball will accumulate snow as will all the snow that was accumulated on the ball as it goes down the hill.
You can do this!
I am here for you!
Until next time!
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