Sometimes all the financial lingo can get a little confusing. Even if you know some of it you might not fully understand it. Compound interest is a concept that has been around for a while now and is known as “…The eighth wonder of the world.” (Said by Albert Einstein) He was a pretty smart guy so I figured I should look a little more into what really is compound interest and exactly how it can benefit you.
Albert Einstein also said about compound interest, “He who understands it, earns it. He who doesn’t, pays it.” Okay, so I don’t know about you but I definitely don’t want to pay for more than I have to. If I’m being honest, I don’t even want to pay for what I have to!
Instead of paying into it, let’s first get into the basics of what compound interest really is.
Back to the Basics
As I was scouring the world’s greatest resource (a.k.a Google), I found an awesome article that talked more in my language about this financial mumbo jumbo. It was Investopedia.com and it simply stated, “Compound interest is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. Compound interest can be thought of as “interest on interest,” and will make a deposit or loan grow at a faster rate than simple interest, which is interest calculated only on the principal amount.”
So, initially when I read that I thought it sounded like some scary stuff that I didn’t want to mess with. It’s kind of like cleaning your bathroom, you know the mess is there but you choose to ignore it because it just stresses you out.
Well, the good news is that I figured this eight wonder of the world out in even simpler terms so it doesn’t sound too scary. I may not be able to clean your bathroom, but I can help you feel not so stressed about learning the basics of compound interest.
1.
Simple interest is just interest on the principal amount.
(If you don’t know what the principal amount of a loan is I suggest you hop on over to my post about 1 Principle you Need to Remember to Pay off your Mortgage.)
Simply put, compound interest is calculated not only on the initial principal (such as, simple interest) but also on the interest earned from either a deposit or loan. You know when you get your bank statement back and you earned like $.52 at the end of the year? Compound interest will include that $.52, instead of just what was initially put in your account. Now you can maybe get $.74! I’m just teasing, you can definitely get more than that back.
It also works when you take out a loan and you have interest on it. If you accidentally miss payments then you start accumulating more interest. Hence compound interest.
Let’s take a little break for a second and put it in number terms. If you have $1,000 and put it in an investment with a 9% return, in 40 years you’ll have $36,000. Having that be the easiest money you ever worked for, why wouldn’t you invest! If instead you invested $10,000 you would have $361,000. Honestly, what are you waiting for?
2.
The same goes for investing. If you invest money into savings, at the end of the year you get some interest on that. Compound interest comes into effect the next year. When you take the amount you originally put in, + the interest earned, and get just a little more interest than the previous year. It continues like that, compounding on the original amount, (which we learned is called the principal) and on whatever interest you accumulate. Therefore, compound interest is a great way to earn money without even working for it.
3.
The key to compound interest is time. If you want to build your savings or retirement then starting as soon as possible is key. Don’t wait until you’re almost retired, do you really want to be dependent on just social security? Starting early sets you up to start growing your money, kind of like a tree. (And you thought money trees didn’t exist!)
If you waste too much time making payments on high interest loans then you’re chopping your money tree down. Don’t wait to make those payments, just pay as much as you can
Cautions of Compound Interest
Compound interest can be something that can hurt you as well, especially when it comes to credit card debt. Pay attention to the interest you have on any credit card debt. Compound interest also comes into play here making it a never-ending payment, (just kidding, it does end eventually. But it does seem like it’s never-ending when you’re paying it!)
When it comes to consumer debt, that’s when it’s wise to heed Einstein’s caution. If you don’t understand compound interest then you will end up paying it instead of gaining it.
Investing
When it comes to compound interest I love how beneficial it is when you’re investing. Compound interest makes it so you gain even more interest on top of the interest you’ve earned and the original amount you put in. It makes the time of wealth building dramatically shorter. Therefore, it also makes you happier because you are making money by just having your money sit. (Wouldn’t that be nice to just get paid to sit!)
There’s your basics of compound interest. We learned that it can be a good or bad thing, depending on how you use it. As long as you pay attention to what interest is compounded when it comes to loans, credit cards, etc… Then you won’t have to pay it. And, if you simply want to invest, making sure you start early is going to help you in the long run.
Roy Miller says
Very good post. This information should be taught in our schools. Children need to learn this stuff before they get grown, in my opinion.
McKenzy Potter says
Thanks so much! I completely agree, I never learned this stuff until way later and wish I would have known about it much sooner.
Maya says
I was so glad someone talked to me about investing and compound interest at 22. It’s really cool knowing that you’ve got money that’s growing while just sitting there- like really cool! I look forward to your future posts!
McKenzy Potter says
I totally agree with how cool it is! I love just watching investments grow month after month. Thanks for the read 🙂