“The rich get richer while the poor get poorer.” urgh, whatever.
You just want to know how the hell they´re doing it right? Well, it´s with the freaky, magic of Compound or Compounding Interest, a magic that makes your money grow new money all on its own!
“What?! That sounds like a money tree?!!”
I know right? It´s crazy but true, Compound Interest is the secret money tree hardly anyone talks about!
First we need to understand what Simple Interest is
Simple interest is a fixed amount added onto the principal amount of money that was either borrowed or loaned. It´s usually calculated as a percentage.
A common example of Simple Interest at work would be your car loan which rarely uses Compound Interest. Seeing as we´re interested in using Compound Interest to build wealth i´ll use investments in the examples as opposed to debt.
Example of an investment with Simple Interest:
You invest €10,000 into a savings account with an interest rate of 8% over a period of 10 years. That means you will earn €800 in interest every year for 10 years, only ever earning money on the initial amount invested.
It would look like this
So you´ve done ok, you´ve made €8,000 on your investment but with Compounding Interest we can do waaaaay better.
Ok, so what the heck is Compound Interest?
It´s the interest earned on the principal amount invested, plus, allllllll the interest thus far accumulated. It´s like a snowball that grows bigger and bigger as you keep reinvested money earned.
Compound Interest is interest earned on interest, earned on interest, earned on…you get the idea.
The first few years can be frustrating as its a slow start but with time the compounding becomes stronger and stronger.
Someone who´s fully exploited the power of Compound Interest is Warren Buffet and the snowball effect is clear when we look at the growth of his Net Worth:
An investment benefiting from Compound Interest will see it´s return grow faster than using Simple Interest as it grows exponentially. Albert Einstein was a huge fan of Compound Interest, calling it amongst other things “the most powerful force in the universe.”
But you don´t have to take Albert Einstein´s word for it, let´s look at an example to really understand how it differs from Simple Interest.
We´ll return to the same example we started with. You invest €10,000 into a savings account with an interest rate of 8% over a period of 10 years. But this time it´s Compound Interest instead of Simple Interest.
In the first example at the end of the 10 year period we have €18,000 so we made €8,000 on our initial investment. Not bad. But with Compound Interest the same amount at the end of the 10 year period is €21,589!!!!
Check it out:
You earned over €3,000 more than if you had invested in Simple Compounding.
To really drum this message home let´s take a look at this example from Fiscard Capital. It is based on an initial investment of €15,000 left to grow over 30 years at 7,5%. With Simple Interest the investment earns €33,750 but with Compound Interest it earns €126,323!!!!
That´s €92,573 more than your friend who invested with Simple Interest!!!!!!!
How long before it starts working?
You´ll reap the benefits of choosing a Compound Interest investment over a Simple Interest one from day one but for Compound Interest to really get its mojo on you need to give it time.
The more time the investment has the more powerful the compounding gets. Which is why it´s so important to start young.
To illustrate we´ll look at this example from Money Under 30.
Michael, Jennifer and Sam each invested $1,000 a month for ten years, then stopped investing and simply let the money grow until they were 65 years old.
However they each started the ten year investing period at different stages in life.
Michael invested from the age of 25 – 35.
Jennifer invested from the age of 35 – 45.
Sam invested from the age of 45 – 55.
All three investors saw their money grow at a rate of 7%.
Michael, Jennifer, and Sam each saved the same amount, $120,000, over a ten year period.
However their ending balances at the age of 65 are dramatically different.
Michael´s end balance is $1,444,969
Jennifer´s end balance is $734,549
Sam´s end balance is $373,407
Young Michael´s going to be logging on to his investment account 35 years after abandoning it like…
Investing at a young age when most people are on a low salary can be tough but putting in the work means Michael ends up with almost four times the amount of Sam who waited 20 years.
The example above is based on all three people investing the same amount. But the awesome news is that if you start young you can invest less than the oldies and still come out on top, as this chart from Merrill Edge demonstrates:
How crazy is that? Even investing only a third of the amount the person who starts ten years early still sees better results!
“But I didn´t start investing in my 20s!!” I hear you gulp! Don´t worry, I didn´t either. All is not lost.
While the best time to plant a tree was 20 years ago the next best time is today. You can play catch up. You´ll have to work harder and invest more but you can do it.
As demonstrated in this chart from the Business Insider:
The 40 year old has to invest double the amount to catch up with the investor who started at age 25. A bummer? Sure, but it´s possible and most people earn more money as they progress through their careers making the saving and investing easier.
A last note on Compound Interest
How often the investment is compounded makes a huge difference on the outcome. The more frequent the compounding the better.
So an investment that is compounded daily will out perform an investment compounded anually as you would start earning interest on interest on the second day, not the second year.
How do I invest to harness Compound Interest?
Any investment that isn´t locked can offer Compound Interest if every time you receive a payment you reinvest it to buy more. You are now getting interest on the new, most recent interest.
Here´s a few options of investments that can benefit from Compound Interest :
DRIP. Dividend Reinvestment Programme. Dividend paying stocks that offer this programme automatically convert dividends paid into additional shares instead of cash. They convert into fractional shares if necessary and are done so free of charge, avoiding the charges you would pay if buying the dividend on the open market.
Bank – Type Investments. Accounts like Certificates of Deposit and Money Market investments compound frequently, many on a daily basis, although they tend to pay out monthly, the money remains in the account where it earns more interest.
Zero Coupon Bonds. Zero coupon bonds are bonds that are purchased at a discount from face value, accumulate interest over the life of the bond and pay out at face value when the bond is redeemed. The accumulated interest generally accrues by compound interest, even though it’s only actually delivered to the bond’s owner once at the maturity date.
ETF´s and Index Funds. A favourite in the Financial Independence community, Index Funds are an effective and inexpensive way to invest. They are designed to track a specific index of stocks, bonds, or another type of investment. For example, an S&P 500 index fund would invest in all 500 components of that market index in order to replicate its performance.
This most important thing to earning money through Compound Interest is to START! Start today and let me know how you got on!