Do you know about compound interest? Albert Einstein once said that compound interest is the eighth wonder of the world. Yet sadly, many people do not fully understand the power behind it. If they did, they might make smarter financial choices and see their finances improve almost immediately.
In this post, I’ll walk you through the basics of compound interest and show you why you need to start taking advantage of its amazing power.
What Is Compound Interest And How It Works
Compound interest is when you earn interest on the interest you’ve already earned. To make this clear, let’s take a step back. With simple interest, you earn interest on your current balance. If you are earning interest monthly, the second month you will only earn interest on your original amount. But with compound interest, you earn interest on your original amount, plus the interest you previously earned.
For example, let’s look at a $100 balance and 10% simple interest earned monthly. After the first month, your $100 earned $10 in interest. After the second month, you earned another $10. You will continue to earn $10 a month under simple interest.
But with compound interest, you earn more interest. The first month you earn $10. But the second month, you earn $11 in interest. This is because you earned interest on both your $100 savings, plus the $10 interest you earned the month before.
At the end of the third month, you will have earned $12.10 in interest. Each month, the amount of interest you earn will get larger because the amount of money earning interest is compounding upon itself.
How You Benefit From Compound Interest
As you can see, you benefit from compound interest by earning more and more money each month. So how do you get the greatest benefit from compound interest? There are two primary ways.
- You get a high interest rate. The higher interest rate you can earn, the more your money can compound upon itself. Unfortunately, there are limits to how high of an interest rate you can earn and still keep your money safe. Inflation also plays a role in the interest rate you can earn.
- You have a larger balance. The more money you have saved the more compound interest can work in your favor.
The second point is the critical point for most people. When it comes to growing your wealth the most, how much you save is much more important than the interest rate you earn. Your interest rate does play a role, but to really grow your wealth the most, you need to save as much as you can.
For example, let’s say you have two people, Jim and Mike. Jim is focused on saving as much as he can, so he saves $1,000 a year. This is in addition to his $20,000 he already has saved. He is earning 2% on his money and does so for 10 years.
Mike is more interested in earning the highest return possible. Mike has $20,000 and found an investment that will earn him 4% for 10 years. After 10 years, who has more money? Mike ends up with roughly $29,600 while Jim has $35,550.
Jim ends up with close to $6,000 more simply because he saved more money. And if you take this example out over a longer time frame, the difference in ending amounts only grows wider.
The answer is to make it a point to save as much money as you can so that compound interest can work in your favor. And while your interest rate isn’t a major factor, make sure you do spend a little time finding an attractive one.
At the end of the day, compound interest is your best friend. It grows your money faster than simple interest and is truly a passive way to grow your wealth. So don’t look at low interest rates as a reason not to save your money.
Remember that as you save more money, the interest you earn will continue to grow larger and larger. Too many people give up when they see a small amount of interest earned. If they only would stick it out, they would begin to see larger interest payments come their way in a shorter amount of time than they thought possible.