What Is Compound Interest? (E) Rated
Compound interest is one of the coolest things in all of numbers! Wikipedia says that compound interest is the addition of interest to the principle sum of a loan or deposit, or in other words, interest on principle plus interest. I think if I use the word interest one more time in this section, my SEO plugin is going to explode!
Let’s break this down and make it a little more user friendly. In my Interest post, we learned that interest is the price you pay to borrow money or the amount you make from lending somebody money. When you make a deposit into a bank, you are technically lending them money.
The bank doesn’t just say thank you and put your cash in a safe and wait for you to come take it out again. Nope, the bank uses that money to make additional loans or investments. In return for letting the bank use your money, they typically offer you an interest rate…although what traditional banks offer in the way of interest is crap!
if you deposit $100 in the bank today, the bank may offer you a 1% annual interest rate. If you go back a year from now and check your balance, you would see $101 in your account ($100 x 1.01). That one extra dollar you made now counts as part of your principle balance. So, if you leave your money in the account for one more year at the same 1% annual interest rate, you would find your account balance to be $102.01 ($101 x 1.01). What’s so cool about compound interest is that your money works for you and earns you more money!
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a 1% annual interest rate (or 1% return on your money) isn’t going to get you very far. Inflation, which is a sore spot for many these days and a topic for a different post, ends up costing you more than the 1% you make on your money in a year. The trick is to get a higher rate of return on your money. For example, if you invested $5,000 and received an 8% return annually, compound interest would help you take just over $23,000 out of the bank 20 years from now! That’s over four times the original amount for you doing absolutely nothing!
Maybe $23,000 doesn’t do it for you. If you think bigger picture though, compound interest can change your life! If you spent ten years contributing $10,000 per year to your 401k and then let that sit for 20 years at 8%, you’re talking about over $466,000 (and that’s low because I didn’t factor in the compound interest for each of the 10 years you were building the $100,000)! This is why it is so important to invest early and often. It allows time to do the hard work for you!
Time For The Analogy
I love coffee. I wake up each morning and the smell of the coffee brewing puts me in my happy place. Admittedly, I may be a little addicted to caffeine. Hey, at least I own it. Typically, I have my one cup (20-ounce Yeti) of coffee each morning. By 9am, I’m feeling the effects of the caffeine in the coffee. But, by about 2pm in the afternoon, the caffeine from the coffee has worn off. This is a little like interest…but not compound interest.
For compound interest, it would be like me having my cup of coffee at 8am, and then another at 10am, then a third at noon, followed by a fourth cup at 2pm. The effects of the caffeine would build on each of the prior cups. By the time I got to my fourth cup of coffee, my hands would likely be shaking due to the caffeine. A couple of things – one, I am not suggesting anyone drinks more than a cup of coffee each day. Two, caffeine can kill you so don’t try.
This analogy works as far as to show you that like the caffeine building with each cup of coffee, so could your bank account with each passing day, week, month, and year of your money being subjected to compound interest. Over time, the results are impactful (just in a good way with money vs. a harmful way with caffeine)!
is something that can change your financial situation. The only downside is that compound interest takes time. It is not a get rich quick scheme. So, if you’re willing to be patient and invest wisely, compound interest can easily turn you into a millionaire. Who isn’t a fan of that?
Be sure to check out my additional posts on how to make more money!
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