Let’s talk about the “8th wonder of the world”
Today, I’m breaking down compound interest. It’s something that has come up a lot in previous episodes, and every one of my guests that have talked about investing bring up compound interest at some point. So, what exactly is it?
Some say it’s the most powerful and most important money tool. Some even say it’s the 8th wonder of the world. What compound interest really is, though, is interest that is calculated on the initial principal amount, plus all of the accumulated interest. I’m going to say that again.
Compound interest, also called compounding interest, is the interest calculated on the initial principal and also includes all of the accumulated interest.
Another way to think about it is interest on interest (AKA stacks on stacks on stacks). What makes compound interest different from your regular old interest is that normal or simple interest is only calculated on the initial principal amount. With compounding, you calculate the larger amount – the principal plus the previous interest.
The rate or frequency at which the interest compounds, or the compound interest accrues, can vary from daily, monthly, to annually. For example, a compound interest at 10% annually will be lower than one compounding at 10% monthly, because you’re compounding, or adding onto, the principal amount plus the interest every month instead of just once a year. Many banks use a daily compounding schedule, while home mortgages and credit card accounts are usually monthly. There can also be a difference in when the interest is actually applied. For example, maybe you accrue compound interest on a daily basis, but it only gets credited to your account and the existing balance once a month. That means that you would only begin to earn even more interest, the compounding interest, from that higher amount once your account is credited each month. Because of course, they have to keep things confusing to keep us on our toes.
Speaking of confusing, there is a way to calculate compound interest but I’m not going to include that here because…for one, I’m not a huge math fan. But if you’re really interested in learning what the formula is, just search for how to calculate compound interest and go nuts. You can easily do it with Excel or a calculator, but it’s more difficult than 1+1=2 so I’m just going to move on.
So why is everybody all jazzed up about compound interest?
Because by earning interest on your interest, you can grow your money quickly. Let’s look at a concrete example.
If you invest $10,000 and it compounds once a year (or annually) at 5%, after 30 years you would grow that by over $30,000 in compounded interest for a total of over $40,000.
Here’s another example:
Let’s say a 25 year old wants to retire at age 65 with one million dollars. By investing $6,642 per year with a compound annual growth rate of 6%, they will reach that million dollar goal. Without compound interest, they would have just the 40 years of savings multiplied by $6,642 per year which equals a little over a quarter of a million. Only a quarter of their goal!
Now are you getting why people refer to compound interest as the 8th wonder of the world?
The Power of Compound Interest: If you invest $10,000 and it compounds once a year (or annually) at 5%, after 30 years you would grow that by over $30,000 in compounded interest for a total of over $40,000.
Of course, let’s not forget that compound interest is also a powerful tool for credit card companies. Just like how your retirement account can grow exponentially due to compound interest, so can your credit card debt. This is why high-interest debt can become so expensive, because your debt can also compound. If you have an interest rate of 20% compounded monthly on a credit card balance of $20,000, you’ll be racking up an additional $4,000 per year!
This is why it’s so very important to pay off your credit card balance every month, especially if you have a really high interest rate.
But, going back to the positives of compounding.
This is why so many people encourage you to start investing early and not wait. The more time your money spends in an account that allows your principal amount to grow, the better! It means more time to add interest to your interest and more interest, whether it’s through a high-yield savings account, your 401(K), or an investment account. In addition to growing your wealth, this can also help you manage economic factors that are out of your control such as inflation or increases in the cost of living.
Even if you have zero interest in the math, the key takeaway is that compound interest means more money, more quickly. So, if you’ve been procrastinating on putting your money into your investment account, get on it! Here’s the sign that you should start making that money today!