Compound interest is one of the most powerful concepts to understand in regard to investing and personal finance. Legend has it that even Einstein called compound interest the most powerful force in the universe. So what is it and why is it important?
What is compound interest?
A simple definition for compound interest is “interest on interest”. So what does that mean?
Think about it this way. Imagine you put $100 into an account and you receive 10% interest on that $100 over the course of a year. After the end of that year you now have $100 + $10 (from interest) which now gives you a total of $110. The next year you now start with $110 and you receive another 10% over the course of the second year. The numbers now look like this $110 + $11 (10% interest on $110) which gives you $121.
The wild thing about compound interest is that if we simply just leave the $100 initial deposit alone and let the above momentum continue (10% interest a year), at the end of 30 years our $100 will turn into $1,745.
What’s even crazier to imagine is what a higher starting amount does in terms of your wealth. For instance, imagine some nice person deposited $10,000 into an account for you at birth that gets a 7% rate of interest and no additional deposits were ever made into that account. By the time you’re ready to retire at age 60, that account would be worth a whopping $579,464.52!
Why is compound interest important?
The reason compound interest is important is that you can let momentum and time work in your favor. The early you start investing and earning additional money on your money, the more of a positive snowball effect you can experience. In our example, you can essentially sit back on $10,000 at birth and have enough money to cover retirement expensive in many parts of the world, e.g. Thailand.
The key here to remember is this: save and invest early and often and let the power of compounding work in your favor.