Compound Interest — How To Earn More and Pay Less.

Compound Interest. Whether you are aware of compound interest or not, there is a great chance you have been affected by it. If money is involved, typically, compound interest will be doing its thing in the background. I think we can all agree that Albert Einstein was a pretty intelligent guy. He once said about compound interest, “he who understands it, earns it; he who doesn’t pay for it.”

All of us are seemingly searching for the next big thing to shortcut or propel our way to success. Now, I am not saying that success can’t happen overnight, but it doesn’t happen that way for the vast majority of us. It is a series of small steps that, over time, produce extraordinary results. Compound interest works the same way.

What exactly is compound interest?

In order to understand compound interest, we first need to understand simple interest. The easiest way to think about simple interest is through a car loan. You are only paying interest on the loan amount for the car. Simple interest is much better for borrowers of money because they will end up paying significantly less money back to the lender compared to compound interest.

Compound interest is best thought of as “interest on interest,” and because of this, the money grows exponentially. Some compound interest examples are credit cards, savings accounts, 401(k)s, investment accounts, and many other investment and loan options that utilize compound interest.

Let’s Get Practical:

Let’s take a look at this example below, where you deposit $5,000 into a simple interest account versus $5,000 into a compounded interest account, both at 5% interest.

In the above graph, compound interest might not seem like a big deal. Are you telling me it’s only $131.41 over five years? Who cares.

Well, before you completely write off the compounding effect, let’s look at something a little more interesting. Let’s say you put $1,000 into an investment account and let it sit for 50 years. Assuming a 10% return, at the end of 50 years, you would have $117,390.85! Crazy right? If you added just $20 a month during this time, your balance at the end of 50 years would be $396,728.90. Unbelievable! This type of compounding effect has the ability not only to change your life but your family’s life.

Small decisions have dramatic impacts overtime on our financial future. Now, when you are about to buy a $5 cup of coffee today, you can see its effect on your financial future. Instead of the coffee just being $5 today, what you are actually giving up is $586.95 in the future! It may not feel like you are gaining progress, but just let compound interest do its thing, and I promise your future self will thank you for it.

Rule of 72

It can be challenging to understand the impact of an interest rate on your financial future. That’s where the rule of 72 comes into play. The rule of 72 gives you the approximate time that an investment will double based on the interest rate. The formula is 72/Interest rate. So, for example, with a 10% interest rate, your investment will double in a little over seven years. With a 5% interest rate, it will take 14.4 years to double your money. Each increase or decrease in percentage points has a dramatic effect on compounding. When evaluating an interest rate, always use the rule of 72 to gauge the effect it will have on your financial future.

Key Takeaways:

• Compound interest earns interest on your interest.
• Great for savings and investments, but can hurt you with loans and debt.
• Compound interest follows an exponential curve.
• Frequency, interest rates, deposits, and starting amount all affect compound interest.
• Save early and often. Time is your friend, use it wisely. The difference between year 1 and year 5 might not be a large but the difference between year 50 to year 55 is a major difference.
• Check Interest Rates for all accounts, banks, and debts.

What does it mean for me?

Compounding interest is a result of frequent, time, interest rate, deposits, and most of all, discipline. If you don’t allocate enough time for compounding to occur, If you withdraw your earnings, if you don’t monitor your interest rates, you dramatically dampen the compounding effect.

Finances are 80% behavior and 20% head knowledge. After reading this article, you have the building blocks to be able to utilize compound interest effectively, but if you aren’t consistent and disciplined within yourself, you will only be hurting yourself.

Find a system, get help, and stay disciplined. And always, you got this!