Compound interest was once stated by Albert Einstein to be “the eighth wonder of the world”. Going on to state “compound interest is the most powerful force in the universe”. What exactly is compound interest and why such high praise from one of the greatest intellectual minds our world has ever known? The full power of compound interest is on display the younger, or earlier you take advantage of it. First, let us understand the basic variables involved in compound interest.
Components of Compound Interest
The more time you apply compound interest to the greater its effect will be. That’s why the earlier you get started as an investor the greater your chance of creating wealth over time.
The rate at which the balance of the investment or debt will grow.
How often the interest is applied to the balance.
The interest is commonly applied either annually, semi-annually, quarterly, or monthly. The greater the number of compounding periods, the faster the balance will grow.
Power of Compound Interest Example
Let’s say, Joe, who is 26 years old, earns a bonus of $10,000 at the end of the year as a performance bonus. He wants to set this money aside for retirement and decides to invest it. For the sake of simplicity, we assume he earns 6% interest compounded annually on his $10,000 investment that he never contributes or withdrawals from.
|Year(s)||Balance||Interest 6%||Closing Balance||Cumulative Return|
This $10,000 investment after 20 years would have earned Joe a 220.71% return and grown to $32,071.35. The interest is being applied to the balance of the investment and is earning interest on interest. Over time this process is magnified. This is the power of compound interest!
It’s also important to understand the flip-side of compound interest if you owe money. For example, in an alternate universe, Joe took out a $10,000 student loan with 6% interest applied annually. That balance begins to accumulate upon his graduation from college. If he never pays a dime towards the student loan balance, after 20 years it will result in him owing $32,071.36! Not only will this have a negative effect on his credit score, but he’s dug himself into unnecessary debt by not making any payments towards the student loan.
Use this calculator for your own illustrations of compound interest.
As Einstein said, “He who understands it, earns it… he who doesn’t… pays it.” Use the power of compound interest in your favor by investing early and making regular payments towards debt. While it’s hard to plan for something far in the future, we can tell you with certainty that making the decision to use this concept now will save you the regret of wishing you had done it sooner. It will help provide financial security, flexibility, and control later in the life.
Levi Sanchez is a CERTIFIED FINANCIAL PLANNER™, BEHAVIORAL FINANCIAL ADVISOR™ and Co-Founder of Millennial Wealth, a fee-only financial planning firm for young professionals and tech industry employees. He is an avid sports fan, personal finance and investing geek, and enjoys a great TV show or movie. His mission is to help educate his generation about better money habits and provide financial planning services to those who want to start planning for their future today!