This is definitely one of the most important concepts that we are going to discuss.
Compound interest is often called the “eight wonder of the world”.
“Those who understand it, earn it. Those we don’t understand it, pay it.“
The basics of compound interest is that you would invest an initial sum (called the principal), which earns periodic interest. All of this periodic interest will than be reinvested, resulting in even more interest earned. If you continue this compounding pattern you will see that your earnings will start to grow at an ever-increasing rate.
We have pointed out in chapter 1. The Basics that most people understand the magical power of compounding interest too late in their lives. This is truly a shame because the longer you can let your investments compound, the more you will earn on them.
If your parents would have activated the power of compound interest before or when you were born, you would be financially independent at a really early stage in life.
On the contrary, if you have to activate the power of compound interest yourself (if you learn to understand it somehow), you will start late in life and miss a lot of potential years of compounding growth!
We will give multiple example calculations below to illustrate how compounding interest works exactly and how much difference time makes in these calculations.
We will begin with a simple initial investment of $1000, which is nothing special for most of us. For convenience we assume you will earn exactly 8% compound interest per year on your principal investment, which is about the rate that the S&P 500 grows.
As you can clearly see in the figure above, we have only invested an initial investment of $1000 (blue line), and thereafter not invested a single Dollar. What you see in the red line (“Future Value 8%”) is the magic of compound interest at work.
In the beginning our principal of $1000 starts to compound at a pretty slow rate, because our total amount invested is low. But as time goes by, our total investment starts to grow significantly because all of our periodic (annual in this case) interests will be reinvested.
This is a realistic illustration of how your investments will grow if you would invest in a S&P500 index fund, which you will learn about a little later in chapter 2.1. Index Funds.
What you can clearly see is that time plays a major role in compound interest!
Next, we will illustrate two completely different examples of two different people.
The first person was extremely lucky, and his/her parents have invested a principal amount of $1000 at birth. After, they have invested a monthly amount of $100. Again, we assume that these investments will compound at an annual rate of exactly 8%.
(At age 18, the child him/herself will continue to invest $100 monthly!)
In this case, the total amount invested from birth to 80 years would be $97.000.
The result you ask? A staggering $7.536.277,35 ($7,5 million) at age 80!
This fortunate child would be a millionaire from age 54, where there would be $65.800 invested in total. And this all without salary included! Again, look at the factor time!
The second person had to find out about compound interest self later in life. This person invests the same principal amount of $1000 at age 30. Thereafter he/she will also invest $100 per month, which will also compound at an annual rate of exactly 8%.
In this case you have to think a little bit different. Year 0 is now year 30 actually (since we start at 30), and year 50 is now year 80. The total amount invested would be $61.000.
The result? “Only” $735.425,80 at age 80! What a huge difference right?!
As you can see we end up with only 10% of the total earnings in case #2, which is a total time span of 50 years instead of 80 years (a whole lifetime). We can therefore conclude that in these extra 30 years we earn 90% more! That is the magic of compound interest!!
The first person would become financially independent pretty early in life, and the second person would (maybe) never become financially independent in life.
Again, all of the above examples exclude jobs and salaries, as they are only meant for informational purposes.
But we are extremely certain that we have made the magic of compound interest crystal clear to all of you readers out there!
Read on to learn a lot more about proper finance on Skills to Mills!
We highly recommend to read the following books on compound interest:
- Money: Master The Game by Tony Robbins;
- The Warren Buffett Way by Robert Hagstrom;
- Stocks for the Long Run by Jeremy Siegel;