Compound interest is extremely powerful. If you haven’t read anything about it before, get ready to be amazed. If you are already aware of the phenomenal power of compound interest, read on to be inspired and get a renewed dedication.
Imagine investing the same amount of money as a friend but ending up with $1,954,834 more than them. How could that happen?
Einstein said that compound interest is the 8th wonder of the world. He wasn’t wrong. People underestimate its extraordinary power – for both good and evil.
Let’s take a quick look to get the concept in a simple way – compound interest 101.
Compounding and your savings – you won’t believe the power
Table 1 shows how Sarah and Tom invest $500 yearly for 20 years, reinvesting interest received (based on 5% interest rate). This re-investing of interest is a key part of making compounding interest become so powerful. At age 65, Sarah is way out in front, why? The only difference between Sarah and Tom in the first table is WHEN she invested.
| Name | Started investing |
Total invested each year |
Total invested over 20 years @ 5% |
Total at age 65 |
Tom & Sarah invested Sarah has $97,190 more = she |
|
| Sarah | 0 – 20 yrs old | $500 | $10000 | $155,976 | ||
| Tom | 21 – 40 yrs old | $500 | $10000 | $58,786 |
Compounding works better if you know how to invest wisely, make your money work harder and achieve a higher rate of interest or return. Let’s take a look at the results if instead of 5% interest, Sarah and Tom were able to get 10% interest on their $10,000.
| Name | Started investing |
Total invested each year |
Total invested over 20 years @ 10% |
Total at age 65 |
Tom & Sarah invested Sarah has $1,954,834 more = she started investing earlier! |
|
| Sarah | 0 – 20 yrs old | $500 | $10000 | $2,296,141 | ||
| Tom | 21 – 40 yrs old | $500 | $10000 | $341,307 |
What a difference an interest rate increase makes! Sarah’s retirement lifestyle at age 65 will be dramatically better than Tom’s.
Remember, the amount invested was the same in each case; both Sarah and Tom invested just $10,000 in each of these tables. Each scenario has significantly different outcomes.
The key takeaways for enhancing the power of compound interest are:
At Wealthwise Education, we have looked at compound interest many times and in many different scenarios. We are still in awe of its power!
How important is time for compound interest?
When you start early, you let time do all the hard work of growing your money. It’s one of the reasons we like helping young people grasp the concept of compound interest at an early age. Parents can also benefit from starting early to save for their children. It’s never too late to invest wisely.
Compounding and your credit card – the evil side
Now let’s see compounding in action when it comes to credit card debt. This is the ugly, dark side of compound interest. How easy is it to become ensnared into helping the banks to make money? Some detailed examples below will really help you to understand the significant dangers of compounding interest when it’s not working in your favour.
In Australia, it’s not uncommon for people to have a $4,000 credit card debt which they carry over a long period of time. In fact, the average credit card debt in September 2017 was $4,200. This means that at an interest rate of 16.58% they pay approximately $700 of interest each year. If people can’t pay this interest, it gets added to their debt and compound interest starts working against them in an even bigger way.
$4000 may not seem like a particularly huge debt. Some people regularly spend that amount on a holiday for themselves or the family. It seems like no big deal especially when everyone seems to be doing it. But here is the danger. Say you got into financial difficulty or decided to purchase other assets or investments instead of paying your credit card off as you had originally intended. Say you were paying 16.58% for the next 10 years (compounded monthly) on this debt. What you owe would get exponentially bigger.
$20,758 is the amount owed after 10 years of compounding monthly – this figure is much scarier and no so insignificant. Compound interest has blown the figure out to more than 5 times the original amount.
$559,053 is the staggering amount for carrying the debt for 30 years. And this doesn’t even take into account any late fees or other charges you may incur! Compound interest has blown the figure out to around 140 times the original amount.
Don’t give your wealth to the banks
Banks base their business model on compound interest. It’s how they make their money, and lots of it. It’s why they regularly offer you an increase in your credit card limit. For every bit of credit card debt you can’t pay off each month, they start making more and more money from you. It’s a way to make the banks rich! Once you have credit card debt that you can’t pay off each month, the sinister side of compounding strengthens very quickly. Every little bit you pay down your credit card debt can significantly help you.
So finally, we hope we have amazed you with the power of compound interest. We encourage you to get on the good side of compound interest and stick with it for the long haul. We implore you to let TIME work for you so you don’t have to do additional unnecessary work. If you haven’t already done so, now is the time to start. Utilising the power of compounding interest is one of the magic keys to becoming financial free and in control of your money.
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