Compound interest is one of miracles of economics that has the proven ability to create wealth without sacrifice. Albert Einstein called it “the eighth wonder of the world,” and Warren Buffet said “it’s like planting a tree that [grows slowly] and provides shade years later.” Compound interest is a phenomenon whose results aren’t noticed until many years have passed, but they are guaranteed.
The best way to describe or define compound interest is with an example. Say you invest $1000 in an investment that pays 7% interest for 30 years. (That’s a very generous investment). At the end one year, with 7% interest paid, you now have $1070. You earned 7% on your original $1000 investment and on the interest. Now, at the end of year two, the 7% interest earned is calculated from $1070. In year two you earn $74.90. Your total money is now $1144.90. At the end of year three, the 7% interest is now calculated on a total of $1144.90. That amount, $80.14, added to $1144.90 gives you a balance of $1225.04. In 3 years your $1000 is now worth $1225.04. Every year your balance increases, and interest is earned on the new total. With Simple interest, the $1000 investment remains the same every year, and 7% pays $70 every year.
With Compound interest, in our example, the 7% is paid each year on an increasing amount. Instead of earning 7% on the same $1000, the earnings are calculated on the $1000 plus the interest earnings from the previous years. Thus it is interest paid on interest. Compound interest will double your original $1000 in 10.3 years. How do I know that? It’s called the “Rule of 72.”
This “rule” is a calculation that determines how long it will take to double your money on an investment. Seventy-two (72) is divided by the interest rate (7%) so in 10.3 years your $1000 will double. In 10.3 years, Simple interest will accumulate only $721. So compound interest puts you up by almost $300. At 9% interest your money doubles in 8 years. With a larger amount at the beginning, and if every year you add extra money to the original investment, you can accumulate a significant amount of money.
So, that’s Compound Interest. Money earning money on the interest it earned. You can accumulate wealth quickly using this method, and most investors take full advantage of this economic gift. No one person “invented” compound interest. The concept has evolved over centuries by men whose financial savvy taught them how to have money make money for you. It is something to know about and use to your every advantage.
References: www.google.com/compound-interest
www.investor.gov/article/what-is-compound-interest
