Compound interest is a very simple financial concept and yet very powerful when used in long term investment.
I think most people nowadays already know how it works and yet they could still easily ignore the concept by not taking advantage of it.
We’re here to reinforce this issue, introduce the concept to the newbie, and show you how to easily estimate how your money will grow overtime without using a financial calculator.
Understanding Simple and Compound Interest:
To start with, let’s try to define the two interest use in investments: simple and compound.
For simple interest, all it means is that you are only earning interest on your original investment. For example, if you save $10,000 in bank that earns 10% interest utilizing the simple interest method, your expected return every year is only $1,000. It’s simple because the interest rate only applies to your initial investment.
On the other hand, investing in a financial vehicle utilizing the compound interest method means that you earn interest on your original investment plus you earn interest on the interest so your money grows much faster.
To illustrate the impact on your investment overtime, let’s take a look at what happens to your original investment of $10,000 invested at 10% annual interest using both simple and compound interest.
For simple interest, the interest earned during the first year is $1,000 with total investment increasing to $11,000 at the end of year one. During the second year, the 10% interest rate is still only applied to the original $10,000 and not on the total investment after year 1 ($11,000), thus, resulting in the same interest earning for year 2 for a total investment of only $12,000 at the end of year 2 and so on.
For compound interest, the earnings and total investment balance will be the same with the simple interest at $11,000 during the first year. However, during the second year, the 10% interest rate is applied to the total amount after year 1 ($11,000), thus, earning an interest of $1,100 with the total investment increasing to $12,100 at the end of year 2.
At the end of year 6, people who invested using the compound interest come up ahead by at least $1,716. Imagine how much more you’ll be ahead if you continue this for 20 years? 30 years?
Compound interest advantage against the simple interest using the above scenario:
- after 10 years is $5,937
- after 20 years is $37,275
- after 30 years is $134,494
- after 40 years is $402,593
Compound interest allows you to grow your money exponentially!!
Now you see why compound interest is the long term investor’s best friend!