If you’re an investor – or anybody interested in growing their wealth – you can’t help but get excited by compound interest. We all want to see our balance grow with the minimum effort, and compound interest makes that a reality.
Compound interest is based on the principle that your interest earns its own interest. It gets better, though: The interest you earned on the original interest also earns interest… and then that interest goes on to earn its own interest, and the bigger your balance, the greater those interest figures become. Interested in interest? You should be!
Let’s look at how compound interest compares with simple, everyday interest. Let’s say, for example, you have $1000 in your bank, and they are offering you a 7% interest year on year. With simple interest, your balance sheet is going to look something like this: At the end of the first year, you’ll have $1000 plus $70 of interest, giving you $1070 total. At the end of the second year, you’ll have $1070 plus another $70 of interest… taking you up to $1140. Year three would bring yet another $70, and you’ll then have $1210. You get the picture – you’re receiving $70 each calendar year.
Now, if we look at a compound interest system, you’ll notice something quite different. Remember: the interest you’re earning is also going to earn its own interest. So, in the first year, you’ll have $1000 plus your 7% interest: $1070. In year two, however, your interest will be 7% of $1070 ($74.90), giving you a total of $1144.90. Year three? That’s going to be $1144.90, plus 7% of that sum, which will give you $1225.05. Even if you’re not the best mathematician, you should clearly be able to see those figures going up and up, and that’s the direction every investor wants their wealth to take!
It is now clear that compound interest makes you a whole lot more money than simple interest does. If you want to get technical, you can look at something called the law of 72. It states that if you take the number 72, divide that by your annual interest rate, it will give you the number of years it would take you to double your money… without having to deposit or contribute any more funds whatsoever. So, to use the example we’ve just gone through, if your interest rate is 7%, you could double your wealth in 10 years. How about that for a tempting idea?
Therefore, logic states that the sooner or earlier you get involved with compound interest, the greater your benefits. The more you deposit, the more compound interest you will receive – it’s a snowball effect, gathering speed, size, and value year after year, and sometimes month after month., or day after day!
While compound interest has clear benefits for those earning the interest, the flipside is that if you owe money, the same compound nature of these accounts can quickly snowball in the other direction. A good example is credit cards. If you didn’t pay off your bills, you could accrue big losses.
In the first year, let’s say you owed $2000 on your credit card. With a 19% compound interest rate, you’d end up owing $2380 – that’s $380 in interest owed. After two years of not paying the bill, another 19% would be added onto that figure, leaving you with a bill of $2832 (the interest would have compounded and risen to $832), and the third year would see another 19% added onto that, leaving you reeling with a bill for $3370. After three years of neglecting, forgetting, or refusing to pay your bills, the amount of money you owe will have increased to eye-watering proportions.
Compound interest can be wonderful if you’re on the receiving end, not the paying end.