Compound Interest
I was about six when I first learned about compound interest from my uncle. We were walking around China Town and came across a bank. He explained how if I deposited money in the bank, I could earn interest for just keeping it there. After many years, it would compound and I would be wealthy!
At that age, I was too young to understand just how powerful compound interest really is. In fact, I never appreciated it until my first finance class in college. Since then, I have been trying to take advantage of compound interest as much as possible.
How Compound Interest Works
Albert Einstein famously quipped that compound interest is the most powerful force in the universe! What did he mean by that?
Well, compound interest simply means that you earn interest on your interest.
Let’s say you invest $1,000 in a mutual fund and earn 10% a year. At the end of the first year, you would earn a return of: $1,000 x 10% = $100.
In Year 2, you would earn a return of ($1,000 + $100) * 10% = $110. In essence, your Year 2 stock return of $110 would consist of:
1. The 10% return on the $1,000 original amount invested ($100) and,
2. The 10% return on the $100 Year 1 profit ($10)
In Year 3, your return would be ($1,000 + $100 + $100 + $10) * 10% = $121. Your Year 3 stock return of $121 would consist of:
1. The 10% return on the $1,000 original amount invested,
2. The 10% return on the $100 Year 1 profit ($10), and
3. The 10% return on the $110 Year 2 profit ($11)
With compound interest, you earn interest on interest on interest on interest and so forth! That’s why it’s the most powerful force in the universe. Like a snowball rolling downhill, your nest egg will only get bigger and bigger over time!
The Components of Compound Interest
The formula for compound interest is:
P = the principal balance (or amount invested)
r = the rate of return
n = the number of times interest is compounded in a year (typically once)
t = time
To have the magic of compound interest work for you, you need to do these three things:
1. Save more money so you can invest more: The more money you save, the more you can invest, and the more interest you will earn!
2. Earn a higher rate of return: The higher the return the more profits you’ll reap!
3. Let the passage of time bring you more profits: The longer you invest, the more time your interest/profit has to compound—this is why you should invest as soon as possible!
How To Take Advantage Of Compound Interest
Now, a lot of people say they can’t or don’t have enough money to invest in stocks or bonds or other asset classes. Even if you can’t save much, investing a small sum of money can reap HUGE gains in the future. I’m going to show you some easy ways to get started.
First, I just wanted to illustrate the magic of compound interest EVEN IF you invest a small sum of money. Let’s say you can only save $200 every six months. If you invest that in a mutual fund that earns 7% a year, by the end of 15 years, your semi-annual investments will have snowballed into a sum of $10,325!
Saving $200 every six months is totally achievable—this means you’ll have to save ~$33 a month. Skip the Starbucks coffee for a week every month or bring your lunch to work and you should be able to meet this goal.
There are multiple ways to get started on getting your compound interest empire started:
1. First, I would recommend using Digit. It’s a great way to save money painlessly. The app works by analyzing your spending habits and withdrawing money on a periodic basis to a savings account.
Don’t worry, digit never transfers more money than you can afford. In fact, it has a no-overdraft guarantee. If/when you need the money back, you can simply text Digit and have the money back in your checking account—no fees at all!
2. Once you have money to invest, there are several routes to go. One way is to use Motif Investing. With Motif, you can buy a basket of 30 securities for one low commission of $9.95.
Most other online brokerages (Scottrade, Fidelity, E-Trade, Schwab, etc) all charge $7+ for commissions to trade one stock! That means it would cost you $210+ to buy a portfolio of 30 stocks like what Motif offers.
3. Another great way to manage your finances and invest is through Personal Capital. Personal Capital is so amazing because if offers you plenty of free tools to manage your wealth. It aggregates the information on all of your accounts (banks, credit cards, everything).
It keeps track of all your cash flows so you can see what and how much you’re spending. Personal Capital can also help reduce fees you’re paying to mutual funds with its fee analyzer. Interested in getting retirement help? Use Personal Capital’s FREE retirement planner feature to see if you’re on track for retirement!
Readers, what do you think? Do you agree that compound interest is the most magnificent force in the universe? Also, I would love if you would share your first experience with compound interest and when you first started investing!