Albert Einstein once called compound interest “the greatest mathematical discovery of all time”. It’s hard to argue with one of the most brilliant minds that ever lived!
The magic of compounding interest is that it puts your money to work for you. Your money makes more money, and then that new money makes even more money. The cycle goes on and on and given enough time it can turn even a modest investment into a sizable sum of money. Let’s look at an example to give you a better understanding of the power of compound interest.
Let’s say you have $1,000 to invest and you are comparing two different investment options. They both will pay you 10% per year. But the difference is that one pays in simple interest and the other in compound interest.
As you can tell from the table to the left, compound interest is far superior. At the end of the first year, there is actually no difference at all. Both options would leave you with a $100 gain and a balance of $1,100. But then the real power of compound interest kicks in.
You see, with simple interest your earnings are the same every year because you only earn interest on the principal amount. But with compounding, your interest earns it’s own interest too. After year one, your interest is based on $1,100 instead of $1,000. The next year it is based on $1,210 instead of $1,200…and on it goes.
While the difference is modest in the beginning, it isn’t long before it takes on a life of it’s own. After 20 years of compounding interest that original $1,000 investment would have grown into $6,727.50. If you had chosen the simple interest you’d have only $3,000. Can you see why I like to think of compound interest as a financial superhero?
How to Use Compound Interest to Increase Your Wealth
As you have just discovered, compound interest is an almost magical way to increase your returns on an investment. But how can you make it work in real life? Well for starters, think about your savings accounts. Whether you use an online bank or a traditional brick and mortar bank, look for the best rates and keep your short term savings in your account so it can grow rather than taking it in and out.
Or start investing in stocks that pay dividends. Instead of cashing out those dividends, you can reinvest them to buy more shares. Then those new shares will earn dividends themselves. Again, the process will start slow but over time it can have a tremendous impact on your earnings.
The key to taking advantage of compound interest is time. The sooner you get started the more time your money has to grow. So if you haven’t already started…what are you waiting for?
To get an idea of how much you can earn through compound interest, plug some numbers into the calculator below. Play around and see what happens when you change the interest rate or the amount you contribute each month.