Much has been written recently about the failings of our school system to provide sufficient education and training regarding financial literacy. Examples abound, but the most often cited failing is that students are not exposed what Albert Einstein once called “the most powerful force in the universe.” No, he wasn’t talking about splitting an atom or nuclear fusion – he was talking compound interest.
Although a more complex topic than can be covered adequately in a blog post, the concept of the time value of money and compound interest can easily be explained, I believe, with a pretty simple analogy.
When we place our money in an interest bearing account like a savings account, money market or certificate of deposit, as long as we leave the money in the account, our deposit earns interest. As that interest is added to what we deposited, and the total amount earns additional interest, we are earning interest on both our original deposit AND the interest that has accumulated. That is called compound interest.
The easy to understand analogy is a snowball rolling down a hill. As it rolls, it accumulates additional snow and begins to grow and pick up speed as its circumference causes it to grow exponentially. (There’s a formula for that!) So when we are saving, compound interest and the time value of money mean that our money is automatically working for us – definitely a very powerful force.
But here’s the catch. When we borrow money, that same principle works – but in reverse. A good way to imagine it is that it is the same snowball, and if we don’t pay more than the minimum payment on our credit cards and work hard to pay down our other debts as fast as we can, that snowball will get bigger and bigger, except in this case it’s coming right toward us! OMG!
The time value of money and compound interest is a very powerful concept. Knowing how it works can be the key to your financial success. So learn all that you can, and start having your money work for you!