What Is Compound Interest? (R) 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!

For Example

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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Speaking of money, I happen to find this wallet super useful!

Now

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

Any beer drinkers out there? This is one of my favorite analogies by far! Ok, so it’s Saturday afternoon and I crack open a beer. As I finish up my first one and go to grab a second, my wife reminds me that we have to head to her parents house and I’m driving so I need to take it easy with my beverages. (I’d argue that because we’re going to my wife’s parents place, I should double fist it)!

If you haven’t bought your wife (or girlfriend) something in a while, you should check this out – it’s f*ing funny!

Only having one beer, I don’t experience anything other than the wonderful taste of my ice cold companion. This is a bit like how interest works. Compound interest is more like the night we have a party with our friends! I’ve had three beers within the first hour, and then I keep going from there.

After six beers, I’m feeling pretty good. Why? Because the alcohol from the sixth beer built on the alcohol from the fifth beer, and the fourth, and third, and so on. The effects were amplified because the alcohol was building on the already ingested alcohol.

Our good friend compound interest works the same way as my buddy called beer. Instead of getting drunk, I’m building wealth. My money is building on the already earned money! Oh, and while it should go without saying, if you drink, drink responsibly.

Compound Interest

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!