There is something magical about compound interest that even Einstein acknowledged in a quote attributed to him.
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it”.
The key for you and I is to make sure we understand it, right?
How Compound Interest Works
I have found the best way to explain how compound interest works is to first show you how simple interest works.
~Novel Serialisation: Heavens Fire~
Simple interest is as it sounds, simple. If you invest $10,000, say with the bank, they will pay you an interest rate, let’s say 4% per annum. At the end of one year, you will have made $400 in interest.
If you were to take that interest to use it for other purposes, but you left the original $10,000 for another year, you will make another $400 in the second year, simple!
Nothing spectacular about that.
Now with compound interest, how it works is that you earn interest or a return, on the return.
If you had left the original $400 that you earned in year one with the bank, you would be earning interest in year two on $10,400 instead of $10,000. That means in year two, instead of earning $400 in interest, you will earn $416.
With no additional work on your behalf, you have managed to create an additional $16 in year two. You are now earning interest on your interest.
If you keep doing that for long enough, you will make significant gains.
The Double a $1 Example
Now I hear you, an extra $16 in the example above is not likely to get you that excited. However, let me show you a far more powerful example of compounding that will get you excited.
If you start with $1 and double it 20 times, how much do you think you will have after the 20th time of doubling? It might surprise you that the result is $1,048,576.
That is the power of compounding. Without compounding, you would keep making $1 every year. However, with compounding, the 20th time you double is worth a massive $524,288.
Now I’m not saying it is possible to double your money every year for twenty years, just showing you an extreme example of the power of compounding.
A Word of Caution with Compounding
Now that you know of the power of compounding, I need to caution you about the dark side of its power. It’s not all unicorns and rainbows.
As well as compounding works for you, it can also work against you.
In fact, banks rely on the power of compounding when it comes to your debt, like a mortgage or credit card. The longer you owe the banks money, the more interest they earn from you.
It is why I often say that the banks want you to owe them money, and stay in debt, because it is how they make more profits. Sad but true.
The Secret Weapon of Compounding
I’ve covered the good and the bad of compounding, now the secret weapon. Time!
The real magic of compound interest reveals itself over time. Therefore it is important to get started with investing your money as soon as possible, let time work its magic.
I often hear people say they will get started investing next year, or sometime in the future. They explain that they wouldn’t make much with what they have this year anyway, so it doesn’t really matter.
Well hold on there, it most definitely does matter.
The problem with that mentality is that it isn’t the first year returns you are delaying, it’s the 20th, 30th and 40th year returns, which you now know are much more significant.
You can’t earn the great returns that come in the later years if you don’t get started.
Conclusion
As a Warren Buffett fan I can’t finish without sharing his thoughts on compounding.
He says that “My wealth has come from a combination of living in America, some lucky genes, and compound interest.”
Since he has grown a personal wealth that now exceeds $100 billion from scratch, you can appreciate the power of compounding, and getting started as soon as possible.
And now that you know not only the power and the dark side, will you be paying your credit card in full this month?
By Andrew Woodward
Andrew is a mindshift, money certified wealth coach and passionate cyclist. As a ‘financial educator’ with over 25 years’ experience he teaches business owners, entrepreneurs, and household CEO’s how to grow their wealth across multiple asset classes, without the need for someone else to do it for them. For the last 7 years he has been teaching people in Australia, New Zealand, Canada and the US, using his unique 3 pillar framework incorporating his money management and investing courses, to secure their financial future – knowing that nobody cares more about your wealth than you!
Website: https://theinvestorsway.com.au/
This is a great article. Compounding is crucial to financial success, starting early is key, the early years may not seem as if there is much movement but the longer we do it the greater the magnitude.
Thanks for the reminder about debt interest compounding, that is often overlooked.