Albert Einstein is quoted as saying any one of the following about compound interest:
- Compound interest is the greatest mathematical discovery of all time.
- Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t, pays it.
- The most powerful force in the universe is compound interest.
- Compound interest is the human race’s greatest invention.
- It is more complicated than relativity theory.
- Compound interest is sexier than your wife.
Well, okay. I made up the last one. And actually, digging into it, I had difficulties finding solid sources for any of these quotes.
But the fact that Albert Einstein’s name comes up when discussing compound interest implies that Al knew of compound interest’s power and respected it (again, no sources here; just me putting two and two together).
What is Compound Interest?
Suppose you invested $1,000 today in the market-based mutual funds (don’t worry, I’ll let you know what these are in a later post). The stock market has an annualized return of 10% over the last several decades.
At the end of the first year, the interest you earned would be $100 (10% of $1,000). Adding in the original $1,000, you would have $1,100 invested in the stock market. Invest for another year, and you will have $1,210.
Some of you may be thinking: “Why isn’t it $1,200? Where did the extra $10 come from?” That is compound interest. Your first year interest of $100 earns its own interest, which is $10. So the interest you earn, if reinvested, earns it own interest… It “compounds” on itself!
Leave the $1,000 invested in the stock market for 10 years, and you will have $2,594. Your interest ($1,594) is more than the original $1,000 you put in! Incredible, indeed!
Don’t believe me? Google “compound interest rate calculator” and try it out yourself! Or build an Excel spreadsheet. Or type it into a calculator. I just did it on my Android. Type in $1,000. Multiple by 1.1. And click enter 10 times (for 10 years worth of investment). You’ll get $2,594.
Why You Should Be Excited!
As Albert Einstein may have kinda, sorta said “he who understands it, earns it… he who doesn’t, pays it.” This one quote is the basis of most personal finance topics.
The “he who understands it, earns it” part references the power of investments and savings. Things like Roth IRA and 401(k) accounts are retirement savings and benefit from compound interest.
Instead of a single $1,000, suppose that you put $1,000 in every year for 10 years. At 10%, you will have $15,937! (Remember: You only put in $10,000.)
Suppose that you have 30 years, your yearly investments becomes $164,494. Again, remember that you only put in $30,000.
If you have 40 years, you put in $40,000, but your investments are $442,593! Wow!
The Flip Side
But don’t forget Big Al. He also said “he who doesn’t [understand compound interest], pays it.”
Credit card debts, mortgages, student loan debts… all debts in general fall into this group. And it’s bad! When it comes to debt, all of that compounding interest is what you are paying, not what you’re earning!
If you have a $40,000 student loan, at 6.8% over 20 years, you will have paid $73,279. $33,279 more than the original amount!
If you had a credit card with $40,000 and only paid the minimum payments, at 18%, it would take you nearly 70 years to pay off the credit card. You would have paid $157,000 total ($117,000 in interest alone!)
Where Do You Go From Here?
That is precisely what this blog is all about! I will show you how to get out of debt so that the compound interest doesn’t kill you.
And I will show you how to invest, so that compound interest will make you rich!