Einstein once said that “Compound interest is the 8th wonder of the world, those who understand it, earn it, those who don’t pay it.”
He was on to something there, to really understand compound interest first we need to look at simple interest.
If Bob has $10,000 in his account, he receives a 10% rate of return per year to leave his money in an investment account and not spend it now, at the end of that year he will receive $1000 which is his simple interest so he will have $11,000 then.
Now he decided to use that $1000 he gets to buy something and reinvest the original amount. He does the same over 10 years in which he will get paid $1000 each year. So, after 10 years he would have $10,000 and have made $10,000 in interest. Total of $20,000.
If he decided to leave that money in there and let the money, he makes increase over time and make more money of what he earned this is how it would look in 10 years’ time:
He would be $5,938 better off after that 10-year time to leave the interest he made there rather than taking it out. This is called compounding, so that essentially money makes more money.
Now if you imagine that over 20 years, let’s look at that example again, without adding to his original amount of money he originally has, first example he would again have $10,000 of his upfront investment and earned $1,000 per year over 20 years, which he will end up with $30,000 over that time after using his interest he would still have his $10,000 original investment left.
Now let’s look and see what it might look like after 20 years with compounding interest:
In this example, he would be $37,275 better off than the first.
This doesn’t even consider he might want to add to his investment over time and this is something I will go over at another time.
We can clearly see that over the long term the money that’s made is making us more the longer we have it in there and don’t touch it. Therefore, investing with long-term goals in mind and understanding this concept can make such a big difference in retirement and starting sooner rather than later is very important.
Which is why it is so important to ask yourself do I really need this right now or is my future self-going to benefit more. Along with also leaving what we have behind to our children and their children, not just in wealth but also knowledge and understanding something like compound interest for a better future for them also.
