Compound interest is the interest earned on the interest earned on your high growth assets and is so effective that Albert Einstein called it the most powerful force in the universe.
This works both ways:
- Sophisticated investors use the power of compounding to grow their assets and become rich
- People with bad debt fall further behind as they end up paying interest on the interest they owe on their credit cards when they don’t pay down their debt.
Compound interest is like planting an oak tree.
One day’s progress shows nothing, a few years’ progress shows a little, 10 years shows something big, and 50 years creates something absolutely magnificent!
Just in case you may be new to the concept of how compounding works, here’s a simple explanation:
Imagine you invest $100 and make 10 per cent return on your money, you’ll earn $10 in interest and at the end of the year you’ll have a total of $110.
If you leave both your original investment and the earned interest in the account, the next year you will earn 10 per cent on the $110, which is $11.
The third year you’ll earn 10 per cent on $121 and so on, for as long as you leave it there. At this rate your money would actually double every seven years because you not only make money only on the money you started out with, but also on the accumulated interest
Take this silly (but true!) story that’s often used to demonstrate how powerful compound interest is – if you start with one cent and double it every day for 30 days, you’ll end up with $5,368,709.12.
Of course, if someone offers you an investment that promises to double every day then you should probably run for the hills as quickly as possible!
But compounding— whether bank interest or another form of investment such as property — has a powerful outcome. It just takes a really long time to become fun and exciting.
So, let’s take a look at that example.
One cent doubled is two cents. Two cents turns to $0.04, $0.04 to $0.08, $0.08 to $0.16, $0.16 to $0.32, $0.32 to $0.64, and $0.64 to $1.28. Nothing very exciting there apart from basic arithmetic.
But when you stick with it, it’s those last few times when the figure doubles that it gets very, very exciting. In the last few days of that month $1,342,177.28 becoming $2,684,354.56, and $2,684,354.56 doubling to $5,368,709.12.
And that’s the case with your investments, too.
It’s not very exciting at the beginning, but compounding becomes a powerful force after years of patience and discipline.« Back to Glossary Index