The Magic of Compounding Interest
There’s may be no such thing as a free lunch – but I have something even better for you. Free Money. If there is one financial concept that will be the key to your financial success its compound interest.
Interest, the cost of borrowing someone else’s money, comes in a variety of types. Of course, interest works in both ways. You are charged interest if you borrow money from a bank, or you earn interest by letting a bank borrow your money. For our purposes lets break down two of the more common types: simple and compound.
I’d imagine that you’re probably most familiar with simple interest. Simple Interest = (Amount Borrowed) x (interest rate) x (number of periods). If I invested $1000 at a simple interest rate of 5% for 3 years year, I would end up earning a total of $150 in interest. My $1000 just became $1150 - simple enough!
Compound interest, on the other hand, is a little more complicated. The big difference is that both the amount borrowed (also known as the principal) and the accumulated interest earns interest. Its formula is a little more complicated (mathematicians at home you can find it here) – but here’s the important takeaway, you are earning interest on your interest. This means that if I invested that same $1000 at an interest rate of 5% that compounds once per year for 3 years, I would end up earning a total of $1,157.63
A brief aside – a bank will tell you how often money is compounded. It can be daily, monthly, annually, etc. Every time it is compounded the bank combines the principal amount and the interest you’ve earned into one sum. After each compounding, the interest rate is applied to this new sum. The important takeaway -- the more frequently your money compounds the more interest you will make in the long run.
Now you’re probably thinking a difference of $7.63 is hardly a magical, especially realizing that this is over a course of 3 entire years. You’re right – an extra $7 isn’t life-changing. However, stretched out over a greater amount of time and now compound interest becomes life changing.
If I left that same $1000 investment in the bank for 50 years. My $1000 would grow to be $3,750 with simple interest. With compound interest, it would grow to $11,467.40.
Same principal investment, same interest rate, same duration -- but somehow, I’m almost $8000 richer. Seems like magic to me.
