We’ve all probably heard that we need to think about retirement, even from a young age. We’re told that we need to get a retirement account, and start saving – the earlier the better!
Have you ever wondered why you’re better off if you start saving for your future earlier? It’s the wonders of compound interest!
Compound interest is the eighth wonder of the world. He who understands it, earns it.. he who doesn’t.. pays it. – Albert Einstein
What Is Compound Interest?
Everyone knows that earning interest on your money is a great thing – but what are the different kinds of interest you can earn?
- Simple interest: Simple interest charges interest only based on principle value; Let’s say you lend $1000 to someone you know. If you lend it to them on a 5% rate per year on simple interest – that friend would owe you $50 each year before they pay you back.
- Compound interest: Compounding interest charges interest on the principle value as well as the value of any interest previously accrued. So in the same example, if you charged your friend a 5% yearly compounding rate, he’d owe you $50 the first year, then 5% of $1050 the second year – $52.50 - (if no payments were made), and so on. The end result is that your friend would owe you increasingly more under compounding interest the longer it took for him to pay you back.
Here is the formula for calculating compound interest – from Wikipedia:
- P = principal amount (initial investment)
- r = annual nominal interest rate (as a decimal)
- n = number of times the interest is compounded per year
- t = number of years
- A = amount after time t
So here’s an example:
An amount of $1500.00 is deposited in a bank paying an annual interest rate of 4.3%, compounded quarterly. Find the balance after 6 years.
A. Using the formula above, with P = 1500, r = 4.3/100 = 0.043, n = 4, and t = 6:
So, the balance after 6 years is approximately $1,938.op.
Why Is Compound Interest So Great?
The reason why compound interest is so great is because not only do you earn interest on your principal balance, or the money you started with – but you also earn interest on your interest! If you are looking to grow wealth over a long period of time, compounding will definitely work in your favor and help you to achieve some exponential gains.
In fact, if you have a long enough time horizon and depending upon the interest rate, the money earned off of the interest alone can be greater than the principal invested at the start! See this chart for details:
Chart via thetaoofmakingmoney.com
Remember, however, that compound interest can work against you as well, so make sure that you’re the one holding the reins, and like Einstein said, that you’re earning it and not paying it.
What do you think about compound interest? Are you earning it or paying it? Tell us your thoughts in the comments!
Want to find out more about compound interest? Check out this great post and infographic about compound interest: Compound Interest Infographic.
Last Edited: 2nd August 2010