Compound Interest: How Money Makes Money

Written by on June 9, 2012 in Money - No comments | Print this page

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Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” Albert Einstein.

When investing the most fundamental and important thing to understand is the power of compound interest.  Understanding how to use compound interest to grow your money is the key to happy and fulfilling retirement. All money that is smartly invested will generate its own income.  When that income is reinvested it also generates income.  That is the power of compound interest; money creates money that creates money … Not only is the amount of money growing its speed of growth is continuously increases.  All compound interest takes is two things.  An initial investment and time to let it grow.

Lets look at a simple example to understand how it works.
A man named Joesph invests $10,000 into an account with a 6% annual return on investment.  At the end of the first year that $10,000 will be $10,600, after two it will be $11,236, after 10 it will be 17,908, it will have more than double after 12 years to $20,121.
Lets say that after 30 years Joesph wants to retire.  In that time period his initial investment will have turned into $57,434.

Start Early
Do you know when the best time to invest is?

All most all finance professionals will say that the best time to invest is when you are young. For many people that does not make since, people have less money when they are younger. Why not just play catch up when their finances are more secure?

Compound interest is why.  Compound interest favors the young. The longer an investment is allowed to grow the larger it will become.

As an example:
Imagine a 20 year old investor that places $2,000 every year, into an investment account earning an 8% annual return. That investor does this  for 20 years (until age 40) then lets it grow for another 25 years without putting anything else into it. It is then pulled out when he reaches 65 and wants to retire. At that time the $40,000 that was invested over the 20 years would have invested to $676,943.28.  If the same investor starts at the age of 30 putting $2,000 dollars into the account for 20 years stopping at the age of 50 then also allowing it to grow the result will be $313,555.72.  Less than half the amount build on the same amount invested.

Keep Investing
Always pay yourself. If you do not know what that means then read up on the Golden Rule of Investing. Even if you start small with continues investing and compound interest your net worth will continue to grow.  Time, patience, and compound interest; they are the key to smart investing.

Compound Interest: The Math
The formula for compound interest is FV   =   P (1  +  r / n)Yn. This article will not explain that formula. For most people it is unnecessary to understand the math. Just find a good interest rate calculator and play with it until the power of compound interest is understood.

 

 

Image courtesy of FreeDigitalPhotos.net

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About the Author

Matt Brand

Matt Brand is QLR's money saving expert. His experience with credit cards and student loans have made him take a strong interest in personal finance, saving money and sharing his knowledge. He is passionate about teaching others how to avoid the trap and make smart financial decisions. View all posts by Matt Brand.