What Is Compound Interest?Disclaimer
Warren Buffett, arguably the most successful investor of our time, attributes his success to being born in America, some lucky genes and compound interest. Albert Einstein called compound interest the eighth wonder of the world.
For some, compound interest is the reason why they never have to worry about having enough money. For others, compound interest is the reason why they will never get out of debt. Those who understand it can apply this powerful force and accelerate their wealth.
One of the most amazing things about compound interest is that it does not discriminate. If you are rich, compound interest can make you richer. If you are poor, compound interest can make you poorer. It does not matter what race, gender, ethnicity or religion you are. Anyone in the world can earn compound interest, and it can change your life.
What Is Compound Interest
The easiest way to understand compound interest is to think of a snowy day. You go outside with the hopes of making a snowman and you begin packing a large ball of snow. Once you have a basketball sized ball of snow in your arms, you begin to roll it along the ground. At first, it appears that nothing is happening at all. It seems like you are rolling this ball of snow around for no reason!
This is the reason why most people give up, whether it be growing a business or growing your wealth. Most people are familiar with linear growth, assuming that the snowball will grow in size at the same rate every few feet that you roll it. The thing is, you are not experiencing linear growth, you are experiencing exponential growth. With this type of growth, the growth rate speeds up the larger something becomes.
Once that snowball is larger, it has a greater surface area to pick up more snow. It may have taken 2 minutes for the snowball the size of the basketball to double in size, but the next doubling cycle will take less time. This is known as the snowball effect.
The same effect can happen with your wealth as well. When you begin to earn compound interest, the returns seem insignificant at first. As you continue to allow your money to grow, the compounding effect becomes greater and greater and the growth rate accelerates. This is why many people refer to compound interest as the time value of money. It’s not about how much you have, it’s about how long you allow that money to grow.
When it comes to earning interest, you can either earn simple interest or compound interest. With simple interest, you earn the same rate of interest every single year. With compound interest, you are able to earn interest on your interest.
Consider the table below. This is the investment of $10,000 at 8% simple interest versus $10,000 at 8% compound interest over five years.
|Duration||$10,000 @ 8% Simple||Return||$10,000 @ 8% Compound||Return|
Compound interest allows you to earn a greater return every single year. While this change seems insignificant, the growth takes place over time. Using the snowball analogy, those initial years are the packing of the snowball. The growth is invisible to the naked eye.
Consider this. If you invested that same amount for 25 years instead of 5, the compounded return would amount to $68,484.75 compared to the simple return of just $30,000. In that 25th year of compounding, you earned $5,072.94 in interest!
“That’s great! But I don’t have $10,000 to invest.” – You
Here is one of the other great parts about compound interest. You can earn compound interest and experience this growth acceleration by investing a little bit each month over time. In this video, Ryan Scribner will show you how you can become a millionaire by simply investing $5 a day.
Rich people understand the power of compound interest, and they have likely been applying it for years. You might be wondering why so many rich people seem to have an endless supply of money. It is simply because they started investing their money and allowing that money to grow into more money over time. They understood the power of compound interest early on and they had the patience to see it through.
The number one skill you need to have in order to get rich is patience. Compound interest will not make you a millionaire over night. Earning compound interest is about as exciting as watching paint dry on a wall or grass grow in your lawn. Nobody became a millionaire overnight by investing in a low fee index fund. It takes time, patience and regular contribution!
On the other side of the coin, compound interest can be your enemy. Consider the credit card in your wallet. The debt on that credit card can compound in the same way that you can earn compound interest.
Let’s say you have a $5,000 limit on that credit card and you made the unfortunate mistake of maxing it out. Your interest rate on this card is a staggering 22% and you are making a payment of $100 a month.
First, how long will it take you to pay off this card?
And second, how much did you pay in total in interest and principal?
Don’t worry, if you are like most people you can’t answer this. It seems like something that would have been useful to learn in school, but I guess Hamlet was more important.
If you were paying off $5,000 in debt with no interest at $100 a month, it would take you just 50 months to pay off that debt. If you were paying off $5,000 in debt at $100 a month with 22% interest, it would take you 137 months to pay off that debt.
To answer the second question, you would pay $5,000 in principal and $8,678 in interest at a total of $13,678!
Would you rather roll a boulder uphill or downhill? Earning compound interest is like rolling a boulder downhill. Paying off compound debt is like rolling a boulder uphill. As we said before, compound interest does not discriminate. It can be your best friend or your worst enemy.
How To Earn Compound Interest
There are many ways that you can earn compound interest. Some of these methods are better than others, as you will see going through the examples. Interpreting compound interest rates can be confusing, so we are going to use the rule of 72 instead.
The rule of 72 is a great way to understand the power of the return you are getting. You simply take the number 72 and divide it by your average annual return. If you had a return of 5%, you would take 72 and divide it by 5 which comes out to be 14.4.
What does that 14.4 mean exactly? It tells you that at a 5% compounded return, you would double your money every 14.4 years. The table below demonstrates the rule of 72 in action.
|Interest Rate||Years To Double|
Moving on now, let’s discuss a few ways that you can earn compound interest.
1. Bank Account
While this is the worst way to earn compound interest, the interest earned from a bank account is compound interest. With a Savings Account, Checking Account, Money Market or Certificate of Deposit, you can earn compound interest.
The table below demonstrates why this is actually the worst way to earn compound interest. On top of that, you would not be able to outpace inflation earning interest rates this low and you would be losing the buying power of your money!
|Account Type||Interest Rate||Years To Double|
|Money Market||0.1%||720 Years|
|Certificate of Deposit||1%||72 Years|
I don’t know about you, but I need to double my money more frequently than every 72 years or more. Let’s go ahead and discuss some other methods of earning compound interest.
2. Stock Market
Investing in the stock market is one of the best ways to earn compound interest. If you are interested in learning more, check out our beginner’s guide to investing in the stock market!
With the stock market, higher risk yields a higher reward potential. Long term stock market investors can expect an average return of 10%. It is important to remember that you will not see this type of return every single year! This is the average return experienced over a long period of time.
At a 10% return, you would double your money every 7.2 years. This is why compound interest is referred to as the time value of money. A young person would be able to experience more of these doubling cycles than an older person. This is why it is imperative that you get started early. If you are a young person reading this, you have a huge advantage because time is on your side!
Another way you can earn compound interest is through dividends. Dividends are regular cash payments paid out to shareholders. A company can decide to retain earnings or share the earnings with shareholders in the form of dividend payments.
When you are investing in a dividend stock, you have two options. The first option is to receive these dividends in cash. The second option is to reinvest these dividends. Reinvesting your dividends allows you to earn more dividends from your dividends (the same thing as earning interest on interest).
BONUS: Free Stock!
Are you interested in getting a completely free stock and earning compound interest? Webull is offering Investing Simple readers who open an account and fund it with $100 a completely free stock. The value of this stock is up to $300. It is based on a lottery system.
Webull is a great trading platform for beginners. They even offer a trading simulator that lets you practice trading without using real money. The only catch is you have to use our link in order to get the free stock. If you simply download Webull from the app store, you will not get the free stock.
3. Real Estate
Another common way that people earn compound interest is by investing in real estate. Consider a flipper for example. This is a type of real estate investor who buys a piece of real estate, fixes it up and sells it for a profit.
In Year 1, they invest $100,000 in a piece of real estate. They fix it up and after expenses they make a profit of $15,000 on the flip. This investor made a return of 15%.
In Year 2, they invest $115,000 in another piece of real estate. They fix it up and they earn another 15% return, but this time it is a profit of $17,250!
At a 15% return per year, you would double your money every 4.8 years. Riskier investments have a higher potential return, and higher return investments will have a shorter doubling cycle.
One of the problems with investing in real estate is that it typically requires a high upfront capital investment. If you are looking to own a two family home, get ready to put down $10,000 or more!
Fundrise has come up with an interesting solution to this problem. Thanks to modern day technology, people from all over the world can pool their money together to invest in real estate projects. There are a number of advantages to this. First of all, the minimum to get started is just $500 making the barriers to entry significantly lower. Second of all, you are investing in a diversified pool of real estate and not just one property.
If you own a two family house and one of the units goes vacant, you just lost 50% of your rental income from the property. If you and 1,000 other people collectively own 10,000 units of real estate all over the world, one vacancy will not make a difference. That is the beauty of diversification.
Fundrise is a great investment option for earning compound interest!
Another way that people earn compound interest is through running a business. This is very similar to the real estate example above. For example, let’s say you had an Amazon FBA business and you were investing in inventory. Your initial investment could yield a 20% return or more, and the profits could be reinvested in more inventory yielding a greater return.
For most people, the best way to earn compound interest is through investing in the stock market. This is going to be the most passive method, as flipping real estate and running a business will be time consuming. It is important to remember that the most important factor when it comes to earning compound interest is time. While having a large amount of capital does help, it is not necessary. You can build a serious amount of wealth for yourself through small contributions on a consistent basis over time.