When I started out learning about finance I was taught the concept of compound interest. I learnt how it works and how to calculate the compound return. Once I understood that I relinquished the concept to the back of my mind.
That was nearly a decade ago. It is only now that I have grown wiser that the concept of compound interest really blows my mind.
It’s didn’t seem to make much of an impact when I was younger, and I suspect it didn’t make much of an impact on the average person either.
Only experienced investors seem to grasp this concept well, but once you understand compound interest it will be one of those money lessons that change your life.
Compound interest is basically an extension on normal interest.
Interest is money paid at a particular rate for allowing someone else the use of the money lent.
Compound Interest is reinvesting the interest earned on the money so that it can earn interest too. Basically, allowing the money to multiply on itself over time.
Let’s give you an example so that you can see how ridiculous the concept is…
Say you invest $1000 of your hard-earned money when you start working at age 20. After one year your investment has earned $70 in interest and the total invested has grown to $1070.
The next year you earn another 7%, but this time it is earned on both the original $1000 invested and the $70 interest from last year. In the second year, you earn $74.90. Growing your total investment to $1144.90.
You might think this seems quite slow. You have earnt a total of $144.90 from the $1000 you invested over two years. Nothing to run home about. But think of it this way, did you do any work for that $144.90?
No – you didn’t do anything for that money. Think of it like employing 1000 little workers, who produced 70 new little workers in the first year, who are also just as eager to work for you day and night. Relentlessly.
But where compound interest really starts to look ridiculous is when you leave it over a longer time frame.
After 40 years of
And we are only talking about investing $1000 here. Imagine when you start to invest tens of thousands.
Think about it, even $10,000 invested in your twenties will return you $10,000 per year in return every year in your sixties, and you will have $150,000 saved. All from that initial $10,000 invested.
If you manage to save an entire years salary and invest it in your twenties, when you retire in your sixties your little workers will pay you the equivalent of your salary each year, and you will have 15 time your salary in capital.
Isn’t that crazy?
That is why compound interest is known as the eighth