The 8th Wonder of the World

Understanding compound interest

Compound interest is truly a miraculous feat. Although the quote about compound interest is attributed to Einstein, its concept has been around since the inception of financial depository institutions. To benefit from compound interest, one needs only an initial investment, time, and lots of patience.

For clarification, simple interest is used in calculations such as auto loans. The outstanding balance is multiplied by a set rate and paid on a pre-established basis. In such cases, the loan payment applies funds firstly to the interest and the remainder is subtracted from the principal balance. Since the interest is being paid and principal being reduced with each payment, the interest is not being added back into the loan balance, allowing the loan to be paid down over time.

Compound interest is when a principal balance is multiplied by the interest rate and the interest amount is added onto the previous principal balance. Since no dispersement is made to the depositor (no part of the original balance being returned to the lender), the balance increases with each cycle of interest calculation (monthly, annually, etc.).

Since the depositor earns interest on both the initial investment and accumulated interest from previous periods, a snowball effect occurs. Given enough time, the snowball becomes more of an avalanche where exponential growth occurs.

To give an example - If someone deposits $10,000 into an investment vehicle that earns 10% annual interest, at the end of the first year, the depositor now has $11,000 at the start of the next annual cycle. The extra $1,000 earned will also benefit from the same rate and be added on. Thus, the depositor would then have $12,100 at the end of the second year. As this continues, the original investment balance will double and continue growing in perpetuity or until the terms of the agreement are changed or funds are withdrawn.

Putting compound interest to work

How does one go about using compound interest for their advantage? There are several vehicles that can be utilized. One could invest in government bonds (anywhere from 2 year to 30 year), Short-Term U.S. Treasuries, certificates of deposit (CD’s offered at most any bank), or even dividend paying stocks. Each of the options carries little risk, which is optimal to prevent loss of original principal and a high probability of substantial reward down the line.

Historically, the most successful investors that use compound interest in their portfolios have followed a regiment of saving (even in small amounts) and adding additional capital into their investments on a set frequency. It could be weekly, monthly, annually, or any schedule that works for the individual, as long as they adhere to their established plan.

Even those without significant income or excess left after paying bills can use this strategy. Each of us has holes in our spending that can be patched up. Identifying leaks in our spending would present capital (that was otherwise being wasted) to put into stable investment vehicles.

The Rule of 72

If you are wondering how long it will take for your money to grow, you could put together a spreadsheet that multiplies the rate and interest earned which feeds into the next row for whatever timeframe is requested. Otherwise, for simplicity sake, you can use head math with the Rule of 72.

The Rule of 72 is simple. Divide 72 by the interest rate you are being paid. This will tell you roughly how many years it will take for the original investment to double. For instance, if you have a CD that pays you 9% annually, you divide 72 by 9 and get 8. In 8 Years, your original investment has magically doubled.

Keep in mind that the numbers presented do not compensate for inflation. Inflation is compounding against every one of us and affects real rates of return. It is a topic that will be covered at length in future articles, as novels could be written on the lies, corruption, and manipulation of the underlying data that is reported to the public. The bright side is, even if the true inflation rate is compounding at a higher rate than your investments, your investments are still growing to help offset this sinister hidden tax.