Compound Interest – Simply Explained
This is arguably one of the most compelling reasons to invest your money instead of letting it sit in a plain old checking account. Compound interest is a phenomenon. A phenomenon that simply helps your existing money, earn more money. And then helps that earned money earn more money (don’t worry that’ll make sense soon).
And the best part is you don’t have to do a thing.
There’s compound interest and then there’s principal interest. Compounding is superior because, with principal interest, the amount of interest is only applied to the principal or original amount of something (e.g., a loan, deposit, investment).
I could visualize how compound interest works, but I was wondering how I can translate that into a simple article that many may be able to understand and then use it to take action. So that’s what I aim to do here.
Let’s use trusty Investopedia (what I like to refer to as the online encyclopedia for investing) to define compound interest. Investopedia defines compound interest as “is interest calculated on the initial principal, which also includes all of the accumulated interest of previous periods.”
The second part of the definition is key, the inclusion of all the accumulated interest of previous periods. I like to compare it to a snowball effect. When you pack snow and roll it into a ball, it’s small. But if you place it on top of a hill and start rolling it, it becomes bigger faster. Ofcourse it grows larger faster because its mass is able to grasp exponential amounts of snow as it rolls.
Who Discovered Compound Interest?
Compound interest has been around for centuries. It’s not completely clear who discovered compound interest. But it dates back to the 13^{th} century where Francesco Balducci Pegolotti created a table with interest calculations for lira for up to 20 years. The concept of compound interest also received attention in the 16^{th} century with the works of mathematicians Richard Witts and Jacob Bernoulli.
Many believe that even Albert Einstein has said that compound interest is the greatest mathematical discovery of all time and that he who understands it, earns it, he who doesn’t, pays it.
Personally, I believe that if you can reasonably avoid paying interest, you should. Reasonableness is key because if you have student loan debt with a 5% interest rate and you take all of your savings and emergency fund to pay it off, that may not be the reasonable thing to do.
How Does Compound Interest Work?
It’s a simple concept really. Let’s say you start off with $1,000 invested that earns interest of 5% annually. At the end of the year, your $1,000 investment will earn $50. So your balance at the end of year 1 will be $1,050.
Now your balance at the beginning of year 2 will start at $1,050. The key here is that you will now be earning interest on the beginning balance at year 2 of $1,050. So the beginning of each year you will have a new, higher, balance that you will be able to earn interest on.
In essence, the amount you start off with continues to compound due to the increased amount of interest you continue to earn each year as compared to previous years.
Check out this simple table below to see the transformation of a $1,000 beginning balance of Amount Invested from year one to an ending balance at year 10:
Year | Beginning | Rate | Interest Earned | Ending |
1 | $ 1,000.00 | 5% | $ 50.00 | $ 1,050.00 |
2 | $ 1,050.00 | 5% | $ 52.50 | $ 1,102.50 |
3 | $ 1,102.50 | 5% | $ 55.13 | $ 1,157.63 |
4 | $ 1,157.63 | 5% | $ 57.88 | $ 1,215.51 |
5 | $ 1,215.51 | 5% | $ 60.78 | $ 1,276.28 |
6 | $ 1,276.28 | 5% | $ 63.81 | $ 1,340.10 |
7 | $ 1,340.10 | 5% | $ 67.00 | $ 1,407.10 |
8 | $ 1,407.10 | 5% | $ 70.36 | $ 1,477.46 |
9 | $ 1,477.46 | 5% | $ 73.87 | $ 1,551.33 |
10 | $ 1,551.33 | 5% | $ 77.57 | $ 1,628.89 |
In particular, check out the last column, Amount Earned. Over time, you are actually earning more in interest. You earned $50 in interest at the end of year 1 and have earned $77.57 at the end of year 10 – an increase of $27.57, all attributable to the compounding effect. It’s important to allow compound interest to keep moving your investments forward.
Again, simply put because you are starting off each year with a higher beginning balance so you have more money to work with each year.
Isn’t it amazing?!
So how does compounding compare to having your cash sit in a bank account if it earns simple interest? The best rate I found for savings accounts these days is 2.48%. This means that in 10 years, $1,000 will become $1,248. Comparing to the graph above, it’s a difference of $380.89 ($1,628.89 – $1,248) or 31%. This is why it is generally recommended by financial experts to keep your cash invested instead of in a saving’s account if you do not immediately need it.
If you want to learn the mathematical side of compound interest, I found this short video to be informative:
Start Early to Capitalize on Compound Interest
This is one reason why so many financial experts say to start saving and investing early on. It’s about time in the market rather than timing the market. The more you continue to put in, the more you’ll be able to feel the power of compound interest.
Once you start that snowball off, it’s just a matter of time until it becomes a big snow boulder with the help of compound interest.
A final note and while I won’t go into the details, simple and compound interest also applies in debt situations. If you need to acquire debt, make sure you choose a loan that uses simple, not compound interest to limit the amount of interest to pay. The good news is the biggest debt people generally have (a mortgage), as well as most car loans, use simple interest.
Join The Discussion:
- Are you at the point where you can really reap the benefits of compound interest?
- How has compound interest impacted your personal finances?
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The time value of money is a powerful concept. And there is no excuse for not making it work. We all have time. Tom
Tom recently posted…Bestow Review – For When You Need Life Insurance
Often times the biggest regret I hear from people in personal finance is I wish I started sooner or in other words, had more time.