The Magic of Compound Interest
It might not sound very exciting, but it’s one of the wonders of the investing world. Just ask Warren Buffett.
“Compound interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t pays it.”
You know who said that? Albert Einstein.
How is it that some people seem to have such a firm grip on their financial future while others find themselves completely lost at sea?
Contrary to popular belief, it’s not all down to the size of your salary.
In fact, the most fundamental factor in wealth accumulation depends on how you allocate the money you earn. Most members of the U.S. workforce find themselves working for their money. Investors, on the other hand, make their money work for them.
When asked, most ordinary people will say, “I can’t afford to start investing.”
Mortgage repayments, credit card bills, student debt… for one reason or another, many people find themselves limping from paycheck to paycheck without managing to put any savings aside.
The truth is that you can’t afford not to start investing. Time is the issue here, not money.
Compound interest is the silver bullet when it comes to growing your wealth because the earlier you start, the more powerful it becomes. However, an estimated 66% of Americans still don’t understand the basic principles of compound interest.
To tackle this, let’s break the principles of compound interest down to see how it works:
Compound interest in interest earned upon interest.
Imagine you have $1,000 to invest, so you put it into the stock market where you hypothetically enjoy an average return of 10% per year.
After one year’s investment, your initial outlay of $1,000 will have grown to $1,100 ($1,000 + 10%).
So you stay invested for another year, still enjoying the average return of 10%. However, instead of just getting an extra $100 again at the end of the second year, you’ll be getting an extra $110 this time.
Because now you’re getting 10% of $1,100 — your original investment of $1,000 + the interest you earned last year of $100.
This is just a small sample of the power of compound interest. Let’s consider a real-life example of compound interest to see how powerful its potential really is over the long term.
Asking the average American to put $50 aside each month — roughly the cost of a daily cup of coffee — might not seem like a lot, but this relatively small sum of money can net you huge gains over the course of your life thanks to the principles of compound interest.
Let’s say at 18 years old, you start your first job and end up spending roughly $50 per month on your morning coffee. By the time you reach retirement at 66, you’ll have spent roughly $30,600 on coffee over your working life.
Not a bad investment to make your mornings a little more manageable, you might say.
Had you put that $50 into a savings account instead, you’d have that $30,600 when it comes to retiring, plus some interest. Of course, inflation will have eaten up a huge chunk of that, so it’s probably not worth giving up the caffeine-kick every morning.
However, had you invested that $50 into the stock market every month — with its average return of 10% per year — you’ll be sitting on a lot more by the time you’re planning your retirement.
After the first year, you’re up 10% from your original investment, which will put you at $660. With another year’s investment plus interest, your investment will reach $1386.
After the third year, with another investment and interest accumulated, you’ll be looking at $2185.
That might not sound like an awful lot of return for $1800 that could have been spent on delicious coffee.
But, by the time you reach 66, your investment could potentially be worth almost $770,000.
Still think you can’t afford to start investing?
The key thing to remember with compound interest is that it doesn’t matter how much you start with, as long as you start now. We’ve all got a finite time in this world, so the sooner you get going, the more of that time you’ll have your money working for you.
Trust us, you’ll thank yourself later.