“The most powerful force in the universe is compound interest.”
You don’t have to be a brilliant award-winning scientist with a bad hair day to appreciate the awesome power of this simple financial principle. The difference between simple interest and compound interest is, well – simple. With simple interest, the money we deposit earns interest on the principal (the amount we initially deposit). If we deposit $1,000 in an account earning 4% interest, at the end of the first year we will have earned $40 in interest ($1,000 X .04 = $40). With simple interest, it is as though we take the interest out of the account, such that the following year we start with the same $1,000.
Compound interest assumes that we leave the interest in the account, such that the first year we earn the same $40. But in the second year, we start the year with $1,040, and the cycle repeats, earning 4% on that balance, yielding interest of $41.60. Granted, that $1.60 in additional interest does not seem like much, until we consider that the following year the interest on the new balance will be $43.26, the following year $44.99, and so on, we see that our money is quite literally growing exponentially.
So what if we can find an investment opportunity that earns a much higher rate of return, say 18% annually? The result is truly impressive. Beginning with the same $1,000, after one year we will have $1,180.00, after two years $1,392.40, and after 3 years $1,643.03, a gain of 64.3% on the original amount. Note that is much more than simply 3 X 18% = 54%. Why? It shows the tremendous value of compounding.
If you are new to finance, it is probably likely that you might not know an investment that can earn a safe 18% per year, compounded, right?. Well, guess what? Your credit card company does, and I am talking about YOU! Just as compound interest is the key to fighting our way out of debt and learning how to have our money work for us, so too is it our evil adversary that throws an ever-increasing shroud over our ability to see the light of a debt free future. Do you think your credit card company wants you to pay more than the minimum and eventually eliminate their 18% return? Not on your life.
As we plot our future career path and develop a sound financial plan, we have two obvious alternatives. We can concentrate our efforts in learning how to work for money, or we can focus on having our money work for us. Trust me – the latter is much more fun!
Harness the power of compound interest, and put your money to work for you.