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I was always taught to listen closely to people who are much smarter than me. So when Albert Einstein, one of the greatest minds to ever walk planet Earth, is quoted as saying, “The most powerful force in the universe is compound interest,” I believe him. So what is compound interest, anyway? Compound interest is defined as “interest calculated on both the principal and the accrued interest.” In other words, compound interest is when money you invest and the interest it has already accumulated continue to earn more interest. This may not sound very powerful, but when you mix in the key ingredient – time – a simple compound interest calculation becomes the secret weapon upon which all fortunes are built. Let’s take a closer look.
The Rule of 72
One simple compound interest calculation that is very useful is called the Rule of 72, which states that 72 divided by the annual rate of return equals the number of years for a given quantity of money to double. For instance, $1,000 invested and earning 9% annually will become $2,000 in eight years because 72 divided by nine equals eight.
Using this simple calculation over longer periods of time, you can quickly see the tremendous power of compounding. As an example, let’s say a 23 year old invests $10,000 in a stock market index fund earning 10% per year. Using the Rule of 72, the fund’s value will double approximately every seven years. So if the 23 year old allows the money to continue compounding until he reaches 65, the fund will have doubled in value approximately six times (65 minus 23 equals 42, and 42 divided by seven equals six). Doubling six times, the original $10,000 becomes $640,000! Simply amazing!
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Compound Interest in Reverse
As amazing as compound interest can be when used to multiply our savings, it can be the cause of a financial nightmare if applied to our spending habits. To what am I referring? Credit cards, plain and simple. When you only pay the minimum on your credit cards each month, the balance you owe grows exponentially. Why, you might ask? Because the interest rates that most cards charge are very high, sometimes as high as 20% or more. Using the Rule of 72, the balance owned would double in 3.6 years at a 20% annual interest rate, if no payments are made. As you can see, it would not take very long for the balance owed to get completely out of hand.
Summary
Compound interest is the mathematical miracle that allows anyone to achieve financial freedom, no matter your nationality, gender, race, IQ, or economic background. A simple compound interest calculation early in your adult life can open your eyes and compel you to take action while its key ingredient – time – is still on your side. So put compound interest to work for you immediately and allow yourself to become a financial success.
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