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How Compound Interest Can Change Your Life

Updated on May 24, 2011

The Life-changing Importance of Compound Interest

"Those who understand compound interest are destined to collect it. Those who don't are doomed to pay it."

Remember this quotation. Remember it the next time you get a Credit Card bill or a Bank Statement. Keep asking yourself the question "Am I the COLLECTOR or the PAYER of Compound Interest? On the answer to this question hangs your future financial happiness. Yes, its that important.

Einstein knew all about Compound Interest

What is Compound Interest?

Compound interest has been called, by no less a person than Albert Einstein, "the greatest mathematical discovery of all time". But you don't need to be as intelligent as Einstein to understand compound interest. In fact, it is a very simple concept.This is how it works. When you invest money you earn interest on your capital. The next year you earn interest on both your original capital AND the interest from the first year. Then in the third year you earn interest on your capital and the first two years' interest. You see what's happening. The concept of EARNING INTEREST ON YOUR INTEREST is the miracle of compound interest. And as you will see, the results of compound interest do sometimes seem miraculous.

The Snowball Effect

Compound Interest is very much like a snowball effect. As your capital rolls down the hill it becomes bigger and bigger. Even if you start with a small snowball, given enough time, you can end up with an extremely large snowball indeed.

EXAMPLE

If you save $100 a month for 40 years and your investments compound at 12% a year how much will you have? The answer is an astonishing $980,000!

How does Compound Interest work?

Compound Interest works on 2 variables - time and rate - the longer your money has to grow, the faster it will grow, and the greater the interest rate your money is getting then the greater will be your rewards.

Remember even small differences in rate and time can produce dramatic effects.

Example - Rate Difference

$10,000 invested at 10% over 15 years will grow to $41,772

$10,000 invested at 15% over 15 years will grow to $81,370

Example - Time Difference

$10,000 invested at 10% over 15 years will grow to $41,772

$10,000 invested at 10% over 25 years will grow to $108,350

Example - Both Rate and Time Difference

$10,000 invested at 10% over 15 years will grow to $41,772

$10,000 invested at 15% over 25 years will grow to $329,190

$10,000 invested at 20% over 35 yearswill grow to $5,906,682

So you can see the enormous difference that changes in interest rate and time can make. You can use these to your advantage.

How do I make Compound Interest work for me?

You can use this knowledge in a number of ways to help your own financial situation:

  1. Don't let the banks use Compound interest against you. Do you have a credit card? If so, do you pay off the full balance each month? No? Then at the moment Compound Interest is working very much against you. You'll be paying something like 1.50% EACH MONTH on the balance outstanding. At the end of month 1 the interest is added to the total and in month 2 the new total will attract interest. This is added to the month 1 total and then in month 3 the interest from month 2 will also attract interest. Your debt will increase DRAMATICALLY. You are in a spiral of ever-increasing debt. You are at the mercy of Compound Interest. The answer? Pay off your Credit Card. Now. Or as soon as you can. Then cut it up into little pieces. Only then can you start to think about using Compound Interest in a positive way, to your immense financial advantage.
  2. Once you've paid off your debts you can start to use Compound Interest in your Investing strategy. The earlier you start investing, the more time you leave for the miracle of compound interest to take effect. Someone who invests $100 a month from age 20 to 29 and then lets their investments grow is likely to have more money at 60 than someone who invests $100 a month from age 30 to 59.
  3. Be patient. Saving for 40 years is obviously something you can't do overnight. You have to exercise patience if you want to feel the full benefit of compounding.
  4. Help Compound Interest work for you. If you invest a lump sum, try to add to it on a regular basis. Then as well as Compound Interest working for you, you are working for you as well! you'll notice your investments accelerate upwards. Plant a money tree and keep it watered. Good Luck!

Comments

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    • profile image

      jailguard 

      6 years ago

      Love this system..I am getting compound interest daily..between 1-2% daily..it's amazing!! I'll let you know how..

    • profile image

      kayode 

      6 years ago

      just came across this. its insightful i must confess, but u didn't really explain how we get started about it. do we just go to d bank and drop our money there or what?

    • gator strong profile image

      gator strong 

      7 years ago from USA

      Good article. Do you know how much money you would have after 30 days,if you started with one penny on the 1st day of any giving month and were able to double you money everyday ? you'll be amazed.

    • bankbowler profile imageAUTHOR

      bankbowler 

      7 years ago

      Thanks for the comments everyone.

      Les Trois Chenes, teaching financial management to your 13 year old is one of the best things you can do for him. I just wish I'd been taught it at a young age.

    • Les Trois Chenes profile image

      Les Trois Chenes 

      7 years ago from Videix, Limousin, South West France

      Hey, brilliant article. I know about compound interest, the rice on the chess board effect, but it's hard to keep in mind how very effective it can be. Of course, you have to allow for inflation as this can invert the numbers. I'm going to show this to my 13 year old in order to try to instill some financial sense into him. Many thanks.

    • profile image

      Anna Hunt 

      7 years ago

      My kids are being taught in school about compound interest using http://www.inspiredtosave.com . Its really good for visualizing the benefits. I wish i had been shown this stuff when i was young.

    • Itswhatyoukeep profile image

      Itswhatyoukeep 

      7 years ago

      Leveraging the power of compound interest is great in theory, and starting early is the key. Unfortunately, the current interest rate environment in the U.S. doesn't lend itself to harnessing this power without the willingness to take on significant risk. Double-digit or even high single-digit returns are unlikely to be had in the near term, unless you diversify into international fixed-income markets. The U.S. dollar is, however, becoming an excellent funding currency to use to put on a carry trade. I echo the sentiments on the avoidance of credit card debt and paying any balances off immediately. The low interest rate environment doesn't seem to have affected interest rates on credit cards as they are sky high, even for those with excellent credit.

    • vaguesan profile image

      vaguesan 

      8 years ago from Osaka, Japan

      if only interest rates were actually that high.

    • profile image

      Clayton 

      8 years ago

      I hope everybody reads this. This affects everybody all their life and they can either use it to make things better for worse.

    • profile image

      scheng1 

      8 years ago

      The reverse is also true. That is how many people get into debt, and ultimately bankruptcy, due to compound interests on credit card.

    • thegreenerme profile image

      thegreenerme 

      8 years ago

      That 15% or 10% sounds great to me, sign me up! The interest rates are pretty low even for the highest CD's right now. Eventually they'll go back up. Nice work!

    • profile image

      loriemclgy 

      8 years ago

      Thanks a lot for this article, i learned more from it. I love it.

    • hubby7 profile image

      hubby7 

      9 years ago from Chicago

      Excellent hub on compound interest! Thanks.

    • mapletree profile image

      mapletree 

      9 years ago

      Thanks for this. Compound interest is truly powerful for those patient enough to let it do its magic. It's also pretty amazing how much of a difference even a fraction of a percent interest makes over time.

    • J. McCoy profile image

      J. McCoy 

      9 years ago from CA (originally)

      Very good article!

    • profile image

      prevajanje 

      9 years ago

      I think i read in one of the books about W. Buffett that he regarded it as one of the greatest formulas, but i do not remember the exact quotation anymore.

    • Philipo profile image

      Philipo 

      9 years ago from Nigeria

      I love compound interest. Thanks for sharing.

    • Jennifer Bhala profile image

      Jennifer Bhala 

      9 years ago from Upstate New York

      I wish I could earn 20% interest on an investment. LOL

    • profile image

      Jonasan 

      9 years ago

      Hi, I read your comment and thank you for helping promote the power of compound interest. Compound interest is honestly the key to a wonderful retirement and a carefree life because of te passive income you reacieve.

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