Understanding the Power of Compound Interest
Albert Einstein is reputed to have said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it”.
What if I said you could meet your dreams of financial wealth and freedom with one simple rule.
Rule #1 of building long-term wealth:
Money invested over time makes extra money, and that extra money can also make more extra money.
The extra money is called interest. Interest is the extra money you get when you lend or invest your money. Making interest on interest is called compound interest, and this is where the magic happens.
I want you to look at this graph:
The green line shows what happens if we invest $10,000 for 35 years and just get 10% interest on our money. After 35 years, $10,000 becomes $35,000. This is simple interest — extra money on invested money.
Now, the red line shows what happens if we invest $10,000 for 35 years at 10% compounded annually. This means that you make interest on the interest, which compounds each year to grow your money exponentially over time! This is compound interest or money made from interest, making interest. Compound interest is how the wealthy get wealthier.
How Compound Interest Works
The beauty of compound interest is that the interest from your investment also creates interest. Let’s take a look at the magic formula that makes this happen:
P is the principle or the total money you start with. In our example, this was $10,000. R is the annual interest rate, which was 10%. N is the number of times the total money compounds or grows. In our example, this happened each year. T is the total time of our investment, which was 35 years.
Here are a few points to know when growing your wealth:
- Invest early. Compounding grows the quickest at the end of the investment period. Time is a valuable asset.
- Your savings will double faster the better your interest rate, so look for the best rates.
- Don’t forget to reinvest any extra earnings, like dividends. The more you contribute, the more you will have.
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