“He Who Understands it, Earns it. He Who Doesn’t, Pays it”. – Albert Einstein
Compound Interest was dubbed “The Eighth Wonder of the World” by Albert Einstein, so you better believe it’s a critical concept to understand. Essentially, there are two forms of interest – Simple Interest & Compound Interest. Simple interest is earned on a percentage of the principal only. Compound interest, on the other hand, is earned on both the principal and accumulated interest from previous periods. As a result of compounding interest, investors can experience exponential growth in their accounts over long periods of time. Overall, there’s no doubt that compound interest is the most powerful force in investing.
Let’s say, for example, that you have $10,000 available to deposit at a 10% interest rate for 30 years. With simple interest, you’d earn a clean $1,000 each year, or $30,000 total after 30 years. With compound interest, you’d earn $1,000 the first year, but that number would exponentially increase each year after that. After 30 years, you’d earn $164,495 in interest on your $10,000 initial investment. That number is substantially larger than the one generated from the simple interest calculation, which proves that compound interest can significantly boost investment returns (especially over long periods of time). The compounding interval (daily, monthly, quarterly, annually, etc.) can also have a major impact on returns. If we take the same $10,000 in the example above compounded monthly at 10%, the return surges to $188,439 over the same 30-year span. More frequent compounding leads to faster growth.
In the end, it all goes back to the Time Value of Money – a dollar today is worth more than a dollar at any point in the future due to its earning capacity (it can accrue interest). Individuals who understand this concept want to be on the side where debtors owe them money, and thus, are able to receive interest payments. Individuals who don’t understand this concept take on too much debt and pay those interest payments. So which side are you on?
Related Page: What is an Index Fund?