How to get rich with compound interest
Compound interest: the magic word when it comes to investing and F.I.R.E. But what is compound interest? And how can compound interest make me rich?
What is compound interest?
Compound interest has to do with math. Do you know who was really good at mathematics? Albert Einstein. There is a well-known story that Einstein considered compound interest the 8th Wonder of the World. We’ll probably never know if Einstein really said it or not, but it is a fact that compound interest is a really powerful tool when it comes to investing and letting your money work for you.
Compound interest is basically interest on interest. It is the addition of interest on the original sum of money. When you don’t pay out the interest, the interest is added to the original sum, and from now on your interest + the original sum is earning more interest. Your money is literally earning more money for you. As you can imagine, this can add up to a huge amount given enough time. But because we’re not all math geniuses, let me show it with an example.
Let’s say you have $10.000 in savings and you want to invest that money. The S&P500 has an average return of about 8% per year, but let’s take 10% to make it a bit easier. Thanks to some handy internet compound interest calculator, this is what would happen with your investments:
In year 0 you earn interest on your initial sum: 10% of $10.000 = $1.000. You know have a total of $11.000 in your investments account.
In year 1 you earn interest on your initial investment ($10.000) and on the interest that you earned in year 0 ($1.000): 10% of $11.000 = $1.100. You now have a total of $12.100 in your investments account.
In year 2 you earn interest on all of the above: 10% of $12.100 = $1.210. You know have a total of 13.310 in your investments account.
…. Let’s pretend I wrote out all 10 years …
In year 10 you earn interest on all of the above: 10% of $25.937 = $2593. You now have a total of $28.531 in your investments account.
I know, I can hear your thinking: how did I go from $10.000 to $28.531 in just 10 years without doing anything? Well, that’s the beauty of compound interest. Because if you look at it mathematically and just added 10% of that initial $10.000 for 10 years, you’d only get $21.000 instead of $28.531. That’s a pretty significant difference! But wait, what if we give it even more time?
Year 20: $74.002 vs $31.000
Year 30: $191.943 vs $41.000
Year 40: $497.851 vs $51.000
Look at that! With compound interest, you’d have almost half a million dollars after 40 years. That is almost 10 times as much as what you’d get with only adding interest on your initial investment of $10.000. Time is an extremely powerful thing when it comes to investing and compound interest. Depending on your age, you might not have another 40 years left, but imagine what this kind of money can do for your children or grandchildren?
When is compound interest not a good thing?
So here’s the other shoe. Compound interest works both ways. It’s great when it’s making you money, but not so much when the interest on your debt keeps going up and up. Apply everything I just showed you, but now imagine it is your credit card debt instead of your investments. Not so fun, right? Remember this when you ever go into debt. Not all debt is bad, there are some solid investments that will definitely pay off after a while, real estate and education being the two most important ones, but still always be careful with debt. Read the fine print about the interest and the installments.
Essential factors to consider with compound interest
Compound interest is interesting (see what I did there) in several ways. It is a way of making your money work for you, instead of working for your money. Here is a summary of how you can take full advantage of compound interest and let your money earn even more money.
Time is money
With compound interest, time is literally money. As you saw in the example above, there is a big difference between 10 years in the market and 40 years in the market. Starting out early is the best way to start. Don’t worry if you missed the early boat though, starting any day is still better than not starting.
Getting yourself early is one thing, but most people or not alone. If you invest $2.500 in the S&P 500 on the birthday of your child, they will have $13.339 on their 21st birthday (with an average return of 8%). If you add another $2.500 each year, the total amount on your child’s 21st birthday is a whopping $143.934. That’s not a bad birthday present.
2. Time in the market beats timing the market
Picture this: you’ve finally saved up some money and you’re ready to invest it. You set up your account, pick your favorite stock/ETF/funds, and click the button. Now you eagerly wait for the price to go up. Except it doesn’t. As soon as you bought the stock/ETF/fund, the price plummets down. And down.
It has happened to every investor and it will happen to you. But trust the math here. Every single study has shown that time in the market beats timing the market. Every single time. So it’s no use staring at that graph and trying to interpret if it’s going up or down, if you believe in the stock/ETF/fund, then you buy it as soon as possible. Because the longer you hold it, the more profit it can generate for you.
3. It’s okay to start small
Not everybody has thousands of dollars lying around to invest or has enough left over at the end of the month to save. The saying “It takes money to earn money” is true, but don’t let that stop you. Even a small amount is capable of giving you great compound interest, as long as you stick with it and give it enough time to grow. Starting with even a little bit is better than not starting at all.
Figure out what the minimum amount is that you can or want to invest every month and set up an automated payment with your brokerage account. This way, you don’t have to think about it. Do you want to try and invest more? Head over here to learn some basic rules about saving.
