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24 December, 2014

“Compound interest is the eighth
wonder of the world. He who understands it, earns it … he who doesn’t …
pays it.”
― Albert Einstein

     Simply put, compound
interest is when you earn interest on the interest you have already earned.
 That is a really big deal, let it sink in.  It is as if the money
you have working for you, 
has children and those
sweet little babies start going out and working for you too.

     This is the real power of
investing that makes the long term nature of investing worth waiting for.
 Over a number of years the interest earned on the interest can and most
likely will be much larger than the initial investment that was made, the
“principal.”
     Let’s explore what this
looks like.  You start today with a $1,000.00 investment that earns 5% per
year.  We will ignore taxes and investment related fees for now, we will
explore these key concepts in a later post.
5% per year earned on
$1,000.00 equals $50.00 a year.  To the casual observer, after 10 years,
it would appear you should have $1,500.00 ($1,000.00 + $50 x 10 years).
 This is a 50% return, $500.00 return/$1,000.00 principal.





     However, because that
$50.00 of interest also earns 5% each year, the second year you actually earn
$52.50 in interest!  Making $2.50 might not seem to be something to get
that worked up about, but lets see how it plays out over the 10 year period.
1.      $1,000.00 X 5% =
$1,050.00 ($50.00 interest)
2.      $1,050.00 X 5% =
$1,102.50 ($52.50 interest)
3.      $1,102.50 X 5% =
$1,157.63 ($55.13 interest)
4.      $1,157.63 X 5% =
$1,215.51 ($57.88 interest)
5.      $1,215.51 X 5% =
$1,276.28 ($60.78 interest)
6.      $1,276.28 X 5% =
$1,340.10 ($63.81 interest)
7.      $1,340.10 X 5% =
$1,407.10 ($67.00 interest)
8.      $1,407.10 X 5% =
$1,477.46 ($70.36 interest)

9.      $1,477.46 X 5% =
$1,551.33 ($73.87 interest)

10.$1,551.33 X 5% = $1,628.89 ($77.57 interest)



     To recap, after only 9 years you have already earned $551.33 in interest!  This
is already $51.33 more than you would think someone would earn after the full
10 years at 5% return.  The curve of the line, getting steeper each year,
is the true power of compound interest!
     After 10 years, with
compound interest, you end up with $1,628.89.  This is a full $128.89 more
than you would have earned with “simple interest.” This is a 62.9%
return, $628.89/$1,000.  This is an extra 12.9% just because the interest
is compound rather than simple.
     Talk about having your
money work for you, the longer the time period and the higher the rate of
return, the more extreme is the difference between compound interest and simple
interest.
     If instead of 10 years,
the time period is 20 years – The difference is $653.30!  With compound
interest the end result is $2,653.30 and with simple interest the end result is
$2,000.00.  The difference in interest is almost as much as the total
initial investment!
     Keeping the same 10 year
horizon but now using a 10% rate of return instead of 5%, you end up with
$2,593.74.  That same $1,000.00 invested at 10% per year using simple
interest gets you $2,000.00.  This is a difference of $593.74 after only
10 years of growth.
     Combining the 10% rate of
return and the 20 year time period  using compound interest you end up
with $6,727.50!  This is more than double the $3,000.00 you would end up
with using simple interest over the 20 year period.
     Einstein was right,
compound interest is the 8th wonder of the world and you would much rather earn
it than pay it!

     More on how compound
interest impacts investing for retirement and borrowing money in later posts!



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