What I’m about to discuss is nothing new to the world of finance. The concept has been around for ages and has been discussed countless times. It won’t be earth shattering news unless you’ve never heard of it before. I’m talking about the power of compound interest.
Why would I bother writing about compound interest, or compounding, if it’s been covered many times elsewhere? It’s because compounding is one of the most vital components of both corporate and personal finance. I would be remiss if I didn’t address this oh so important subject. In fact, how could I even get away with calling this site Personal Finance Utopia if I did not have at least one post explaining what compound interest is all about and why it’s so important?
Life Without Compound Interest
If compound interest did not exist, the world would be a sad place with drastically increased poverty levels. This is because compounding, when used in your favor, can make you very wealthy. Let’s start with an example:
It’s your 10th birthday and your parents are throwing you a nice party. All your friends are there, but so is your Aunt Susie. Of course, you love Aunt Susie, but man does she embarrass the heck out of you. There’s not much you can do though when she pinches your cheeks and loudly exclaims how seemingly just yesterday she was helping to change your dirty diapers. All of your friends are snickering. You really just want her to leave the party. It doesn’t happen. In the end, it’s all worthwhile because you open up the card she gave you and inside is a crisp, brand new $100 bill. You tell her “thanks” while enduring another round of cheek pinching and then you’re finally done with Aunt Susie for the time being.
Now, what do you with that $100? You could spend it. Alternatively, you can save it. You choose the latter. If compounding did not exist, one of two things would happen with your saved money:
- You’d stash away the $100 and nothing would happen with it. It would just sit there…under your pillow or in a piggy bank, it really doesn’t matter. The point is the $100 stays $100. In fact, in the future it would be worth even less due to inflation, but let’s ignore that aspect for this example.
- You decide to put your cash gift into a bank. This bank only offers simple interest on your deposit. It’s not ideal, but, hey, it’s better than just letting the $100 lay around collecting dust. The bank offers an 8% interest rate (yes, I know it’s pure craziness for a bank to be offering a savings rate that high – we’re using a “fake” world where there’s no compound interest anyway so just bear with me). After one year, the bank pays you $8 of interest earned. That’s calculated by taking the $100 x 8% interest rate = $8. After the 2nd year, you’ll get another $8 off that $100. Let’s say you leave it there until your 16th birthday when you withdraw everything to use in the purchase of a car. At that time, you’ll have $148. That amount consists of the original $100 plus $8 of earned interest for 6 years (see table below). Not too shabby, eh? But there’s something even better…
What is Compounding?
Compounding occurs when you reinvest your earnings and those earning earn! This phenomenon allows for exponential growth of your money. Let’s get back to the $100 your Aunt Susie gave you. Alright, now this time the bank is still going to pay you that 8% interest rate, but instead it will be compounded annually. After the first year, you’ll have the same exact amount you had in the simple interest example above which was $108 (consisting of $8 of interest plus your original $100).
Year 2 is where the magic starts to happen. Instead of earning another $8 on your $100, this time the 8% interest rate will be applied to the $108 you have from year one. In other words, you’ll be earning interest on the original $100 deposit plus the $8 interest earned from Year 1. If you take $108 x 8% you get $8.64. Just like that, the power of compounding has made you an extra $0.64 in Year 2. Now, that doesn’t sound like much, but let’s take a look at what your balance would be after the 6 years of compounding:
As you can see above, your final balance is $158.69. That’s an additional $10.69 just from compounding. Pretty neat, eh?
Extolling the Virtues of Compound Interest
You might be thinking an extra $10.69 over six years isn’t all that impressive. That amount probably wouldn’t help your car purchase out too much except for perhaps a couple of extra air fresheners. Aunt Susie only gave us $100. What if she’d given us $1,000? First, if she’d given you that much money, you’d be perfectly fine with all the cheek pinching and embarrassing stories in the world. Secondly, after that same 6 years, $1,000 compounded annually at 8% would turn into $1,587!
As you can see, with larger sums compounding can produce impressive results. Also, the more periods compounded the more you’ll end up with. If you let that same $1,000 compound annually at 8% for 50 years the end result is $46,902. If it’s compounded monthly for that same 50 years: $53,879!!
If you aren’t already doing so, take advantage of compound interest and start investing. Get your money making more money. Your Aunt Susie would be proud of you 😉
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