Some accountants have called compound interest “the eighth wonder of the world”; it turns a little bit of money into a whole lot of cash if the right investment moves are put in place. While Albert Einstein may have referred to it as the “greatest mathematical concept ever”, you don’t actually have to be a genius to understand and take advantage of this concept.
Simply put, compound interest allows you to earn interest on your interest income. It’s essentially a fundamental concept of wealth creation which investors use to their advantage. I don’t know where you fall here, but it has been widely agreed that those who understand compound interest, earn it, those who don’t, pay it.
The bottom line is, by investing the interest you earn on an investment, you earn more interest as the amount grows. But before you get all excited about that, let’s take a moment to understand how compound interest works.
What is Compound interest?
When most people think of interest, the first thing that comes to their mind is debt. However, interest can actually work in your favor on the money that you invested or saved. Compound interest can be defined as the interest earned on the principal amount as well as on the accumulated interest over the previous periods.
Think of compound interest of as a cycle that allows you to earn interest on top of interest, essentially causing wealth to snowball rapidly. It makes a deposit or an investment grow much faster than simple interest –which is the type of interest that is calculated on the principal amount only.
You will not only earn interest on your initial deposit/investment, but you also get additional interest on top of interest. This is why your wealth can exponentially grow under a compound interest arrangement –it’s like letting your money work for you.
For example, if you invest $10,000 in an investment offering 12% interest per year, you could end up with a return of $31,058 in a period of 10 years. That is an impressive additional earning of $21,058 on top of your principal. On the flip side, if you choose to be paid the interest at the end of each year, your total earnings will only be $12,000 in interest.
How to make Compound Interest work for you
As you can see, you don’t need to be an investment guru or an economist to make compound interest work for you. The simplest way to make compound interest work for you is to save in the highest interest savings account. The interest your investment earns will be added to the account balance, and the next interest will be calculated on the largest amount (Principle plus previous interest)
When it comes to creating wealth through compound interest, time is your friend. The longer you keep your investment to compound, the more interest you will accumulate. This is the reason financial advisers always recommend starting your saving scheme as early as possible. What most people don’t realize is that even small weekly deposits can make a huge difference.
Decide how much you want to save
While time is the biggest determining factor, the amount and frequency of your investments matter too. The amount you save is however dependent on your income, your expenditure, your overall budget and your retirement goals. Your retirement budget might also be affected by factors such as your life expectancy, inflation and your lifestyle. You might want to make some changes in your habits if saving is not part of your monthly budget. Make saving a priority, even just a little per month is better than nothing.
Decide where to save your money
After figuring out how much you can save per month, the next step is deciding where you would like to save your money. Our calculations above assume that you saved your money in an asset that earns you a yearly interest of 12%. There are many options for which asset you would want to invest in some of those could be P2P loans, Index funds, Stocks and Crytocurrency.
Starting your savings plan when still young is the best way to benefit the most out of compound interest accounts. Like a snowball effect, the higher up the hill you start your snowball, the bigger it would have grown when it gets downhill.
Consider these two examples;
John, a 21-year-old intern saves $300 per month in an asset that offers an annual interest of 10% for 6 years. At the age of 27, John quits his job to pursue personal interests, and by this time had deposited $21,600 of his own money. At this point, even if he doesn’t contribute any more money, his total amount would be 1 million by the time he hits 64 years.
Now, let’s compare that to Christin who postponed saving until she was 30. While she is still young enough to attain that 1 million, it will be a little tougher on her. Christin would have to save $300 for another 34 years to attain that $1 million at 64 years of age.
As you can see, John only invested $21,600 for a period of 6 years to get $1M at age 64 while Christine had to invest $126,000 in a period of 34 years to attain the same amount –just because she started a while later. The bottom line – getting richer is easier the earlier you start investing.
As you can already tell, the second magic phrase for creating wealth with compound interest after “start young” is “be patient”. Compound interest is a powerful concept of creating wealth, but decent outcome requires a long time of waiting. It usually takes at least 10 years to get significant results depending on how much you’re saving, but if you’re patient enough, the interest from your later years will overtake your savings as the primary source of growing your wealth.
The later years will yield bigger gains as you now focus on lowering the costs of investment. At some point, you will not have to save anymore from your pockets because the snowballing effect would be large enough to match your savings goals.