Do you remember learning about exponential growth in your algebra class?
When you have an equation to work out, and then you map a curved line on some graph paper. It starts out low and gradual, but when it finally takes off, it skyrockets!
Exponential growth explains how compound interest works, and—if you use it right—this powerful formula could make you millions of dollars.
Compound interest is earning interest on top of interest.
When you invest money, you’re expecting to get a return on your money, meaning that you should end up with more money than you originally put in.
If you leave that money alone, compound interest applies the interest rate to the total new amount of money earned, so that it builds over time.
Simple interest, on the other hand, does not accrue, once you pay it or earn it, it happened for a particular period.
It’s not added to the next payment period the way compound interest is.
Compound interest is the secret sauce for building wealth, and it is the most powerful concept in Finance.
How does it work?
Let’s say you invest $1,000, and, just to keep it simple,it earns 10% a year in interest.
After one year, you’d have $1,100, the original money plus $100 interest that you earned.
The second year, you’d have slightly more, $1,210, because you’re earning interest on top of interest.
The investment compounds, or builds up, over time.
Now $1,210 doesn’t seem like a big deal at first, but it becomes a big deal later.
If we leave that $1,000 alone for 40 years, and it compounds annually at 10%, it will grow to a sum of over $53,000! And all you put in was $1,000!
The number of compounding periods will determine how quickly your investment grows. Interest can be compounded daily, weekly or yearly.
The power of compound interest:
To help you see the power of compounding in action,
I want to tell you a story about John and Ron, two guys who got serious about investing for retirement.
They picked good, growth stock mutual funds that average an annual return of about 11.6%, just under the long-term growth rate of the S&P 500.
Starts investing at age 21
Invests $2,400 every year
Stops contributing money at age 30
Total amount contributed: $21,600
Starts investing at age 30
Invests $2,400 every year
Contributes money until age 67 (a total of 37 years!)
Total amount contributed: $91,200
At age 67, John’s investment has grown to $2,547,150, and Ron’s has grown to $1,483,033!
Nine years made a difference of over one million dollars.
The secret to benefit from the power of compound interest is time.
Compound Interest Formula:
All right, math nerds, it’s your time to shine. Here’s how you calculate compound interest:
A = P(1+r/n)nt
P is the principal (starting amount)
r is the interest rate
n is the number of times the interest compounds each year
t is the total number of years your money is invested
A is your final amount
If you’re experiencing hard time to remember algebra class in school days. don’t worry.
Here are 3 simple steps to calculate your compounded returns.
Step 1: Go to www.calculator.net
Step 2: Choose Investment Calculator.
Step 3: Add appropriate figures.
Step 4: Click Calculate and Done!
The combination of compound interest (or growth) and time is the key to investing.
But it won’t make you rich overnight.
It’s all about having the right mindset.
Stay focused. Be patient. Be disciplined. It will pay off in the end!
Remember: Interest that you pay is a penalty. Interest that you earn is a reward.