"He who understands it, earns it; he who doesn’t, pays it,”
Albert Einstein calls compound interest the "8th wonder of the world." This coming from THE Albert Einstein! If that doesn't highlight the importance already then I don't know what will. Once you understand the concept behind compound interest as explained below you can really see how it can become essential for generating some serious wealth.
What is compound interest?
Compound interest simply is the use of time to make your money multiply. By saying time I don't mean a few months or a couple of years, I mean 10, 20, 30 years where the rewards and benefits will be beyond what you expect. You can see the effect of compound interest over short periods but it is no where near as powerful than if applied over the long term.
It works by basically you earning interest on interest on your money. You deposit a sum of money and earn interest on that. Then after a certain period of time you then earn interest again but this time it is interest on the original sum of money you deposited AND the interest you earnt last period. Assuming you have not withdrawn or touched the money. This then creates the compounding or snowball affect as your money can just keep growing and growing and growing on itself over time.
Basic example of compound interest:
You deposit an initial sum of $10,000 which has a 5% yearly return. After the first year you make $512 in interest. You leave this money with the initial deposit ($10,512) and after the next year you earn $538 in interest. Fast forward to your 5th year and you earn $609.15 in interest for that year. After the 5 years your initial $10,000 is now $12,792. Now you might be thinking, $2792 is not much over 5 years, and i agree with you! But as said above let's talk about this money over 10, 20 and 30 years.
After 10 years you're looking at $16,470, good but still not spectacular. How bout after 20 years.....? $27,126, ok this is a bit better but how bout over 30? After 30 years your $10,000 without touching it will become $44,677! Thats an extra $34,677 in your bank account without you having to lift a finger. Not bad for doing sweet FA! Now this is the most basic of examples but how about this....
Just think if you were to do the same initial investment but instead over the 30 years you deposit $100 a month. Now a $100 a month is not much at all, thats around $25 a week which in other posts I will show you how easy that is to save. But back to the point. If you were to invest that extra money your $10,000 will look more like $127,903 now over that 30 years, CRAZY! The power of compounding is truely phenomenal. The longer and more you invest over time the greater the outcome!
Real life compound interest example:
Take the stock market as a common real world example where compound interest can play a huge part. If you buy shares in a dividend paying company and reinvest those dividends back into more shares with that company you are utilising the power of compound interest (and you may not even realise that!). Your shares are buying more shares which are just increasing the overall value of the holding on that company. And if none of that made sense well then thats ok! Check out this article i wrote on what stocks and dividends are!
ASIC Compound Interest Calculator
I find myself now and then on the ASIC compound interest calculator playing around with the numbers and seeing how powerful compound interest can be. It truely is the 8th wonder of the world. I will leave the link for the compound interest calculator below and encourage you to punch in some numbers to see the different results and what you could possibly achieve!
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