The world is not short of get-rich-quick schemes, and you may brush aside this title because it sounds like one. But it is not. On the contrary, compound interest is the eighth world wonder. – Albert Einstein. He further said that those who understand it earn it, but those who don’t comprehend it, pay it.
In this article you will learn more compound interest so you can move from paying to earning it. In this article, we will examine compound interest, how it works, why it is a wonder and how to calculate it. We will also share tips on where you can invest and benefit from this eighth wonder of the world.
What is compound interest?
As the name implies, it is the interest applied to the principal investment and the interest accrued from the previous investment period. It is unlike simple interest; interest is calculated and applied to the initial principle only.
Compound interest works both ways. Lenders apply it to loans and /investors require it from various investment vehicles. In either case, the investor gains because they earn more. On the other hand, the payer loses because they pay more. Here is more on how compound interest works and how to compute it.
How does compound Interest work?
Einstein loved math and was baffled by the practicality of compound interest; it applies even in the natural world. Scientific research shows one can use the same phenomenon to describe the growth patterns of a sample population (like bacteria). The principles are similar; the initial generation multiplies exponentially by including the additional individuals added over time.
In the financial world, we express compound interest using a formula:
A = P(1 + rn)nt
A represents the total (future) value of the investment
P is the initial principal
r represents the applicable interest rate (often the annual interest rate)
n is the frequency of compounding in a year
t represents the total number of years
Although the formula may seem complex, it is not. For those who don’t like math, free and reliable compound interest calculators are available on trustworthy websites like the US Securities and Exchange Commission.
Below is an example of how compound interest practically works in the financial world.
Bobby and Jamie graduated from college and started their jobs when they were 20. Bobby was an astute saver and began saving $100 in a retirement plan immediately. He earned an average interest of 4% every year.
Jamie was not very keen on saving for his retirement. He began building his nest egg when he was 45. But was determined and managed to put up an initial investment of $10,000. In subsequent months, he contributed $200 consistently. Both funds earned the same interest. The table below shows each individual’s accumulated total:
Bobby’s fund in $
Jamie’s fund in $
AGE 20
0
0
AGE 30
14,407.33
00
AGE 45
49,975.00
10,000.00
AGE 60
114,030.00
66,066.05
AT 67
159,534.00
105,849.32
Calculations done using SEC’s compound interest calculator.
Bobby’s $100 multiplied to over $100,000 after saving for about 40 years. From the comparison, we can also tell that the most crucial factor of compound interest is not the amount nor interest rate. It is time.
Although Jamie had a considerable initial investment and doubled the regular deposit, his fund did not surpass Bobby’s. On the contrary, Bobby saved a comfortable amount every month. He also did not struggle to put up a significant initial investment.
Why is compound interest so powerful?
By applying the principles of compound interest, one can significantly boost the size of their investment. Moreover, there is little risk. There are plenty of low-risk investment options that harness the power of compounding.
As we have seen, it is how nature works. A simple saving of $100 every month would accumulate to a comfortable retirement fund. What matters is the duration, compounding interest periods (frequency of applying interest in a year) and the saving consistency. Not the principal or amount saved every month.
How to benefit from compounding
Everyone deserves an opportunity to benefit from compound interest. Unfortunately, not all the savings avenues in the modern financial system will accord you this benefit.
Commercial banks have products like savings accounts with some interest. However, the rate is often lower than the general inflation rate. Eventually, you would lose purchasing power.
Fortunately, there are low-risk saving and investment options that you can use for long-term investment. Alternatives like well-balanced mutual funds and a Roth IRA account use the compounding effect.
Look out for the compounding period and frequency, interest rate and financial stability of the provider. If you are considering a mutual fund, check out the portfolio mix and governance of the fund. Don’t ignore due diligence.
Conclusion
Compound interest is a sure way to grow wealthy over time. It is not a get-rich-quick scheme. Heed Einstein’s advice and understand it.
Start by reading this article once again. You will learn how to calculate it, discover the most essential factors and discover investment avenues that grant you the option. Are you a beneficiary or victim of the wonder of compound interest? The answer depends on how well you understand it.
