Compound interest is arguably the most important financial concept out there, yet most people are unfortunately unaware of it. For some, compound interest is the reason why they never have to worry about having enough money. For others, it is the reason why they will never get out of debt.
Those who understand it can apply this powerful force and accelerate their wealth. Those who do not understand it will often let their debts snowball out of control, effectively paying back perpetually growing debts to their creditors.
I'm sure you have met someone in the past who always seemed to be in debt. Maybe it was a retail store credit card or having a lease payment on a brand new vehicle. Most people in these situations do not understand this powerful concept.
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.
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.
Here's the difference; 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, which explains the snowman example I used.
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.
It's not about how much you have, it's about how long you allow that money to grow.
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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.
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! Want to try this out on your own? Here is a link to my favorite compound interest calculator.
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. The main factor that matters here is how long you invest for, not how much you invest. While both are important, having a large investment isn't everything.
Rich people understand the power of compound interest, and they have likely been applying it for years.
So... why do the rich keep getting richer?
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.
Or, in some cases, they inherited a large sum of money. If you simply live off of the interest or growth of your account without touching the principal (or your original investment) it is possible to never run out of money!
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.
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.
While this isn't the best way out there to earn compound interest, interest earned from a bank account is compound interest. With a Savings Account, Checking Account, Money Market or Certificate of Deposit for example, you can earn compound interest.
Interest rates paid from banks are extremely low. According to ValuePenguin, the average interest rate on a savings account right now is just 0.01% in the US.
Stuffing your money in the bank isn't going to make you a millionaire. You need to invest that money to allow it to grow! In fact, one important factor to consider is inflation. On average, inflation is around 2% per year. That means if your average return from an investment does not exceed 2%, your are actually not even growing your money!
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 8 to 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.
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).
Another common way that people earn compound interest is by investing in real estate. If this type of investment interests you, check out our comprehensive guide on real estate investing for beginner's!
So, here's one of the ways that you can earn compound interest through 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. You can read our full review of Fundrise here.
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!
When I was younger, I can remember my dad sitting down with me and showing me a compound interest calculator. Unfortunately, not everyone is as lucky as I was to get exposure to this at a young age.
As mentioned earlier, the most important factor when it comes to earning compound interest is time. The more time you have, the longer you can allow your money to grow.
If you are wondering when the best time is to start, the answer is now!