Compound Interest Explained – Use The Power to Build Your Wealth

If you want to build wealth from investments, then you had better embrace the concept of compound interest.

Understanding compound interest is extremely easy. And benefiting from it requires nothing other than time to provide you with massive returns.

In this article, we’ll look at:

  • Simple interest.
  • Compound interest (and the secret to mega profits).
  • Where to invest to benefit from compound interest.
  • The Einstein connection.

 

Compound interest explained

Simple Interest vs Compound Interest

1. Simple Interest

As long as you know what “interest” is then you are good to go.

For example, you save money in the bank, let’s say $100 to keep the numbers simple.

You are lucky enough to be receiving 5% interest on your deposit… which is pretty wild stuff at the moment!

Anyway, at the end of the year, you receive $5 extra in your account, so your balance is now $105.

Nice.

If you take that $5 out of the account and leave the $100 in there, you will get another extra $5 at the end of the next year.

Take that $5 out… and so on and so forth. You earn $5 every year.

That is simple interest.

2. Compound Interest

To earn compound interest all you need to do is leave the extra $5 in your account.

That means your balance stays at $105 dollars and at the end of the next year, you receive more than $5 in interest.

$105 x 0.05 = $5.25

Leave that interest in your account and your balance is now $110.25.

The next year you’ll get interest on the whole balance which will be:

$110.25 x 0.05 = $5.51

You then leave that extra money in your account and the interest keeps building up each year.

Look at the table below:

Year Balance Interest Total
1 100 5 105
2 105 5.25 110.25
3 110.25 5.51 115.76
4 115.76 5.79 121.55
5 121.55 6.07 127.62
6 127.62 6.38 134
7 134 6.7 140.7
8 140.7 7.04 147.74
9 147.74 7.39 155.13
10 155.13 7.76 162.89

At the end of year 10 you would be getting $7.76 in interest, or $2.76 more than year 1, or 55% more than year 1.

Yes, if you think about the interest as your income, then your income would be 55% higher.

And you didn’t do anything to achieve that increase.

You just sat back and collected.

The Secret to Massive Wealth – Adding Fresh Capital

The above example is if you just put a solitary $100 in your account and left it.

But, of course most people will be actively accumulating money and constantly saving over the same period.

When you add new capital every year you will obviously see even bigger growth in your interest payments.

This is illustrated in the table below, with $100 dollars extra added each year:

Year Balance Interest Total
1 100 5 105
2 205 10.25 215.25
3 315.25 15.76 331.01
4 431.01 21.55 452.56
5 552.56 27.63 580.19
6 680.19 34.01 714.2
7 814.2 40.71 854.91
8 954.91 47.75 1002.66
9 1102.66 55.13 1157.79
10 1257.79 62.89 1338.68

In this example, after 10 years your income would be $62.89. Or 1157% higher than year 1!

After a few more years of adding the extra $100 every year, then the amount of interest that you received would exceed that $100 capital addition.

You would be earning more in interest, than you were actually adding to your account.

Therein lies the only real issue with the wonder of compound interest… It takes time to really see the benefit of exponential growth.

So, if nothing else, the lesson is start as early as you can… start today. Don’t delay any longer.

Where to Invest for Compound Interest

The examples above use a flat rate of 5% interest. It is meant to be from a bank account.

However, it’s difficult to know what the future holds for interest on savings accounts in the current financial climate. Regardless, the amount of interest that you receive on a bank account will likely have an upper limit.

You can also use compounding to your advantage if you invest in stocks that pay dividends. If you invest in good companies, then you can save and reinvest those dividends.

If the company is growing its payout year on year, then you have an even bigger compounding effect to enjoy.

Effect of Interest Rate

The actual rate of interest that you receive has an enormous effect on the outcome of your investments.

If you were getting an interest rate of 10% in the above example, then at the end of year 10 you would have $1753 in the bank earning you annual payments of $175. 3400% higher than year 1.

The Einstein Connection

Einstein is rumored to have said that “Compound interest is the most powerful invention in the universe”.

While, it is unlikely that he said those actual words, where there is smoke there is fire. I’m guessing somewhere along the line, he made a comment to someone about compound interest.

Einstein was a smart guy.

Whatever he did say about compound interest, it’s likely to have been positive.

Time to get compounding, I’d say.

Note: All the above calculations were done by hand, so there will be rounding errors. If you want to work out returns on your investments using the compound interest formula, you don’t need to laboriously go through the process yourself. Using a compound interest calculator is much quicker and easier.

What do you think about compound interest? Are you using it now? Where are you investing your money? Please leave your comments below.


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