This is one of the coolest concepts you can learn.
Understanding the power of compound interest will literally blow your mind. It is the simplest and safest way to build your wealth.
There are two key things that you need to understand first:
1. Your greatest investment is time
2. You will need to be able to stick to a plan
It is never too late to start, and no amount of money is too small, but the sooner you start the better, as more time gives you more opportunities to make some serious financial gains.
So, what exactly is compound interest?
Compound interest is the interest earned on your initial principal deposit, plus accumulated interest. Not only are you gaining interest on your original deposit, but you are earning money on your interest. This is known as interest earned on interest. Interest can also be compounded annually (such as the examples), monthly or even daily. The more frequent interest is compounded, the more your balance will grow.
Let’s spice it up a bit with a metaphor
The power of compounding is a bit like how wildfire evolves. Once ignited, a small ember is created. This ember may seem insignificant at first, but overtime it gets progressively bigger and bigger, seeking out fuel and spreading. As it grows, it becomes bigger at a much faster rate and this blazing inferno is not something you will want to extinguish.
The longer you are disciplined in re-investing your returns from compound interest or contributing more money to your investment, rather than spending, the greater your financial benefit. With more money invested, the impact of returns gets bigger and your pool of money increases. Over time, your investment will build to a size where it generates its own momentum, and you will get some hot returns.
How does it work exactly?
Here is a breakdown of how compound interest works over 30 years with an annual return of 10% and a one-off deposit of $5,000.
As you can see, an investment of $5,000 turns into $87,247 after 30 years of re-investing returns.
The benefit of compound interest may not seem very big to start with, but it can make a huge difference over time. You are literally making your money work for you, with zero effort on your part.
Let’s look at the power of time with an example
At age 20, you invest $5,000 in a share fund with a 10% annual return. You then reinvest your dividends for the next 10 years.
Your friend waits until she is 30 before investing. Like you, he invests $5,000 a year, but continues to do so until he retires at 65.
By the time you are both 65, you would have contributed $50,000 and your friend $180,000.
Your friend would earn more as they contributed more, right?
Not quite. You end up with $2,709,677 and your friend only $1,645,197.
That is the power of compound interest and the power of time.
As you can see from the table, the more time you give yourself, the more financial wealth and freedom you can give your future self. Imagine if you invested $5,000 every single year.
So, time is your friend
It can be hard to keep investing your returns for such a long period of time.
After a couple of years, a new car or holiday may seem like a more rewarding option, particularly if you do not continue to deposit additional money into your investment and only let it grow purely off interest. But if you look at how much the investment grows beyond the 10th year, the power of compounding really takes effect and the rate the investment grows gets progressively bigger.
Where to start
There are calculators out there that can help you calculate how much your money can grow using compound interest. The website below is an example of one you can use so you can plug in your own numbers and see your possibilities.
You can check out a compound interest calculator here
If you can stick with it, then it will truly be life changing.
Money does not grow on trees. But with a little bit of discipline, care, and time, you can grow your wealth with minimal effort involved.
Thanks for reading!
And now I will end on a cheesy quote – Invest in yourself. And your future self will thank you for it.