Friday, 1 January 2021

How Does Compound Interest Really Work?

If you want to become wealthy one day, then you absolutely must become familiar with compound interest. This is it, the most powerful wealth-building tool in existence. I'm going to be talking about how you can build unimaginable amounts of wealth by harnessing the power of compound interest. 

Albert Einstein once called compound interest the 8th wonder of the world. Compound interest is like a bonus, you get paid for having a bunch of money and leaving it alone. And the longer you leave it alone, the bigger the bonus gets.

It works like this

  • Invest $1,000 at 12% Annual rate of return
  • Year 1: Interest on $1,000 investment only
  • Year 2: Interest on $1,000 + year 1 interest

Let's say you invest $1,000 and your investment earns 12% interest per year. The first year, you only earn interest on your $1,000 investment, but the next year, the magic starts happening. Not only do you earn interest on your original $1,000 investment, but you also earn interest on the interest from the first year. That's compound interest 

  • Invest $1,000 12% Annual rate of return
  • After 30 Years It will be worth $35,949.64* When compound monthly*

It might not seem like a whole lot at first, but keep that going for 30 years and you'll wind up with $35,949.64. If you like the idea of being able to invest $1,000, leave it alone for 30 years, and wind up with over $35,000, then give this article a thumbs up. Add a couple zeros to your initial investment, and you can start to understand just how powerful compound interest can truly be.

Calculating Compound Interest

I'm going to show you two ways to calculate compound interest 

Fair warning: there is a little bit of math involved in this article, and I'm not gonna lie, some of it can seem pretty intimidating at first, but I'm going to do my best to break it down so you can easily understand it.

Method 1: Manually, Step By Step

For this first method, I'm going to show you my work in Google sheets, but you can do it just as easily with a pen, paper, and a calculator on your phone. 

Before we continue, it's important that you understand the concept of compounding. 

  • Compounding is when the interest you've earned is calculated and then added to the principle.

  • Compounding happens once a month, but it can happen once a year, once a quarter, or even once a day. 

  • The more frequently compounding happens, the more compound interest you'll earn.

Let's start with a $1,000 investment, this investment is projected to earn 12% interest per year, and it's compounded monthly. I want to figure out how much money I'll have if I just let this money chill out and earn interest for one year

With Google Sheets, I'll start with entering my initial investment of $1,000. I have my annual interest rate of 12%, but because interest is going to be compounded monthly, I need to divide that interest rate by 12, since there are 12 months in a year. if I divide 12% by 12, I end up with 1%. That's my monthly interest rate

Next, I divide 1% by 100 to get my interest rate in decimal form. I wind up with 0.01. Now, I can multiply my initial investment or principal by the interest rate, figure out the interest generated in one month, so I take $1,000 and multiply it by 0.01, and I get $10. In one month, my investment will generate $10 of interest

The $10 of interest is then added to the original $1,000 investment to get the new principal amount after the first month, my new principal is now $1,010. For the second month, I take a new principle of $1,010 and multiply it by the interest rate 0.01, and I get $10.10. Add that back to the principal, and my new principal is now $1,020.10 

If I repeat that process for ten more months, my final balance will be $1,026.83, And that, in its most simplified form is how compound interest works.

You may be saying, I only made an extra $6.83 over an entire year, thanks to compound interest. Why the heck is Einstein calling it the 8th wonder of the world?

The truth is that compound interest really doesn't do a whole lot in the beginning when you're just starting out. But as you'll see in the next example, what it does over a long period of time is absolutely bonkers.

Method 2: The Compound Interest Formula

I'm going to show you the second method for calculating compound interest. Which replaces all the busy work we just did with a single formula. The formula looks like this

P(1+r/n)^nt = A

  • P = original investment (principal)
  • r = annual interest rate
  • n = number of times compounded per year
  • t = time in years
  • A = final amount

Let me break it down so you can understand it more easily

  • P = is the original investment you started with

  • r =  is the annual interest rate, is the number of times the interest is compounded per year

  • t =  is the number of years we want to project for.

  • A =  is the final amount after all the interest is compounded and added.

Not so bad, right?

Let's give it a try with the example from before, and fill in the blanks. 

$1,000(1+0.12/12)^12*1 = $1,126.86

  • P = $1,000, our original investment 
  • r = 0.12, our annual interest rate in decimal form. 
  • n = 12, the number of times the interest will be compounded in a year, once every month
  • t = 1 since we're only projecting for one year. Plug all that into a calculator and we'll find that 'A' = $1,126.86

Exactly the same result as before, but much more quickly this time.

Now that we've got this great formula to work with, let's use it to figure out what our final balance would be if we just let our investment chill for 30 years.

Investment Value After...

I plug in all the same numbers as before, except I change T to 30 this time. And the answer is;

  • 30 Years: $35,949.64
  • 40 Year: $118,647.73
  • 50 Year: $391,583.40

That is what's so incredible about compound interest. If you put $1,000 into an investment earning 12% per year, compounded monthly at age 20, and left it alone until your 70th birthday, you'd wind up with almost $400,000. And that is why Albert Einstein called compound interest the 8th wonder of the world. It is truly incredible just how much wealth can be built with some compound interests and some time

I encourage you to try out some compound interest calculations for yourself to begin to understand how powerful it can truly be.

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