Why you should love Compound Interest!
Updated: Jan 2, 2020
Do you know the superpower of investing?
Compound interest is amazing! It uses the power of exponential growth to give you more money than you could imagine your somewhat small savings rate accruing.
Who gives compound interest?
Compound interest comes from many places. Most people experience compound interest in a bad way, by means of debt. On average, credit cards can have a 19% interest rate and people in their 20s might have around $2,500 of debt. If we really quickly look at the numbers, minimum payments will let you pay the $2,500 off after a little over 9 years and a total payment around $4,000, which means you end up paying 60% extra in interest alone. Boy, I wish I could get investment returns like that! (Please note that this assumes you stop accruing debt, which is unlikely for most people who are in a bunch of debt.)
Back to the original question: who gives compound interest? Banks will say they give interest, but since it’s less than 1%, I don’t count those. High yield savings accounts, investment brokers, bonds, real estate, and alternative investments can all give interest throughout the year that compounds over time.
What is compound interest?
Compound interest is explained in The Richest Man in Babylon as having your gold work as little slaves that produce more gold that will also work as little slaves. “Make thy gold multiply.”
Why would money multiply? You know how you can pay someone to use their car, house, bike, or basically anything (commonly refereed to as renting)? You can also rent money from people, which also means you can let others rent money from you. If someone needs cash right now, you have no incentive to give it to them, unless you’ll be paid for the time that they use your money. This is interest.
It is fair; the person loaning the money can’t use their money and is taking a risk in possibly losing all of that cash, so they deserve to receive all of their funds back with some extra compensation for the time they didn’t have access to it.
That is debt-based investing: you rent money out to people and they pay you back a little extra over time. However, there are other kinds of investments that also generate compound interest.
Suppose you have a friend who wants to sail to Africa to get some diamonds and bring them back to sell them. He is willing to do the work, but needs help paying for the trip. So the two of you make a deal that you will finance the trip for a share in the profits. Now you are partners and joint owners of the endeavor. This is somewhat like stock trading.
When you buy a share in the company, you aren’t really loaning money to the company: you are joining in as a miniature partner, proportional to your contribution. As such, you are entitled to a portion of the profits, even though you don’t do any of the work.
Compound interest is the accrual of this interest making added interest on top of it. Let’s say we invest $1,000 with an annual interest rate of 10%.
Notice how the interest grows every year? And the speed the interest is growing is also increasing? That is because the interest is making interest. That is the beauty of compound interest! If you invest $1,000 at 10% interest for 20 years, you’ll end up with $6,727.50: a 572% increase! With simple interest, you’d only increase by 200%, but compound interest gives you almost three times that amount (in this case).
That is the power of compound interest.
Where do you get compound interest?
When should you start using compound interest?
NOW!!! (Or yesterday, if you could.) The earlier you start, the better. Let’s look at an example. If an 18 year old starts investing $200 per month at 9% interest (compounded annually), he will have around $1,500,000 in his investment account. However, someone who starts 20 years later at age 38, investing $600 per month at 9% interest will have around $740,000 at age 65.
Let’s think about that for a second. The total payments the 18 year old will make is about $112,000 and the total payments the 38 year old will make is about $194,000. That means that the guy who started later, even though he was investing three times the money and put in almost twice as much, ends up with less than half the money that the guy who started earlier has.
Compound interest is like a hockey stick: it really curves away near the end, so the longer you are in the game, the better off you will be. Thus the best time to start investing is as soon as possible. Right now! (Unless you have debt, then work on that so interest stops compounding against you.)
I started investing at age 22, and I feel like that wasn’t early enough. I have plans for my future children to start investing at birth, so they will have more time for their interest to grow. As you can see, 20 years makes a big difference with compound interest.
Why should you love compound interest?
Compound interest is our salvation for retirement. You might have about $2,000,000 pass through your hands throughout your lifetime. Most of that will probably not be saved. Let’s say that you manage to save half of that, so you retire with $1,000,000 in cash. Now you are living on a finite amount of money. If you spend $40,000 per year, you have about 25 years you can afford to live, which doesn’t sound too bad, but what about inflation? On average, your money might be losing its value by 3% per year, so by the time you retire, a million dollars might not look like as much money. (Let's not even mention medical bills that you'll probably be flying through in those retirement years.)
Investing helps you keep up with inflation and helps your money sustain itself. Your nest egg could last indefinitely if you withdrew certain amounts (usually around 4% or less) to compensate for inflation and grow to the same value every year. (That's probably another post though.) If you can understand the power of compound interest, you will love it.
How do you utilize the power of compound interest?
Utilize the power of compound interest by researching investment opportunities and taking advantage of them. There are many fantastic platforms available to laymen like us now, so investing is easier than ever!
Disclaimer: I am not a financial advisor, so please do not take my word for it. Think about it for yourself and see what you can do to make a better future for yourself. All investments have their risks, so be sure you can afford to lose the money you’re investing and make sure you do your research.
I have a little math equation for you. Think about how much money you could afford to invest. Then take that principal and multiply it by 1.05^n, where n is the number of years you have until retirement. This is only 5% interest, but see how it grows over time? A little closer to the S&P average is multiplying that principal by 1.1^n. Isn’t that a beautiful number?
Try to make a plan with your spouse (if you have one) to utilize the power of compound interest.