Albert Einstein was an absolute genius. His theories led to new ways of looking at time, space, energy and gravity. When this man is quoted, all ears should be listening!
To that point, it makes me happy to know Einstein was quoted at least once on money…
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
— Albert Einstein
I’ll start this week with a bold statement: compound interest is the most essential money lesson you’ll ever learn. Period.
There are two sides to it. It’s the #1 key to unlock serious wealth, or if you’re not careful, it can cost you a lot of money.
Last time I checked, compound interest is not taught in schools (at least about saving, investing and borrowing). So I’m not surprised if this is your first intro to it.
Don’t worry, I’ll take it slow and make sure all of the ideas are easy to learn, and even simpler to apply. Remember, this is really important to understand. Please take your time, and let me know if you have any questions in the comments below!
What is compound interest?
There are two forms of interest – simple interest and compound interest. Despite the naming convention, both are easy to understand.
Think of simple interest as “interest-on-initial” money. It is very straightforward and relies only on the initial amount you owe/invest. For example, 5% simple interest on $100 is $5.
Compound interest, on the other hand, relies on two variables. It is not just “interest-on-initial”, but it’s also “interest-on-interest”. Interest grows exponentially because of both factors. It has a “snowball effect” and gets bigger with time.
It’s a small difference that has an enormous impact on your money – in both of good and bad way.
Compound interest can cost you a lot of money
Not understanding compound interest can cost you a lot of money. It’s the way a lot of loans and credit cards calculate your interest.
Remember, this type of interest has a “snowball effect.” That means if left unpaid, you’ll not just owe the money you borrowed, but money on top of money (or said differently, interest on top of interest).
Let’s take a look at a simplified credit card example to show my point…
Let’s say you charged a new piece of furniture to your credit card for $1,500. If left unpaid for 12 months at 20% interest, you’ll have racked up $330, or nearly ¼ of your initial sale in interest! The chart below shows the breakout of both your initial cost plus interest. You can see how it snowballs quickly!
Note: For you financial gurus, in this example, the interest is compounded monthly (for everyone else, no need to worry!)
Now imagine you didn’t pay it down for 2 or 3 years. The snowball effect could make it grow even more!
This is why you need to be especially careful with high-interest debt.
20% interest will compound much faster than 4% for the sheer fact it’s a bigger number. If you have any high-interest debt, it’s important to start paying it off as soon as you can… even before you start investing! Paying that type of debt off will be better than just about any investment you could make!
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Compound interest can benefit everyone (it’s not just for the rich or the financially savvy)
I hope my introduction above made it clear that you don’t need a Ph.D. to understand the basics of compound interest. It’s not some fancy stock trading idea that only a handful of people comprehend. Just about anybody can wrap their head around it… meaning everyone can and should benefit from it!
The idea of “interest on top of interest” is a good thing when you’re making money. When you invest long-term, you can build a nice nest egg because of the “snowball effect.” Time is your friend here – you want a nice long runway for your snowball to grow.
Compound interest is so powerful, waiting to invest means you’ll lose out on a ton of money (read my post here). Someone who invests even a small amount can earn a lot over 20 or 30 years!
Let’s go through one last example to show my point…
- Scenario 1: A young single male (or female) started his first job at age 25 – he decides right away to invest $250 each month. It’s a fair amount of money initially. As he grows through life though, he gets married and his own earning potential increases, and his initial investment becomes very manageable.
- Scenario 2: A young couple decides to start investing together at age 35. They choose to set aside $500 each month, 2x as much as Scenario #1. Relative to both of their incomes and expenses, it’s a fair amount of money. Over time though, their investment is more manageable as their careers progress.
- Scenario 3: A more mature couple waits until later in life, after having kids and traveling to start investing at age 45. They focused on their careers early on, and today they take home a decent paycheck. They contribute $1,000, 2x as much as Scenario #2, and 4x as much as Scenario #1.
As you can see from the chart below, by age 65, each scenario will have earned a different amount of money:
- For Scenario 1 (25-year-old single): $1.2M
- For Scenario 2 (35-year-old couple): $915K
- And for Scenario 3 (45-year-old couple): $668K
(Note: Assuming they can earn 9% interest per year)
Time is money! By prolonging the decision the invest, our fictitious couple in Scenario #3 has lost out on over $500,000 despite them contributing 4x as much!
Here you clearly see the “snowball effect” at work – you can see how compound interest can exponentially grow an investment.
The above example also shows us that you don’t have to be rich and invest a lot of money to enjoy the benefits of compound interest. When it comes to compound interest time is your best friend. Remember, you want to give yourself enough runway to build a large snowball!
SWP Action Steps
Beginners – Do you have any high-interest debt? Anything over 8%-10%? If so, you need to start paying this down quickly. Every dollar counts! If you’re not in this situation, start thinking about how compound interest can work for you. Don’t wait – remember, time in the market is more important than the size of your investment.
Intermediate – Assuming you don’t have any high-interest debt, ask yourself if you’re maximizing your investment contributions. Remember, time is your friend when it comes to maximizing returns from compound interest. Start as soon as you can! Be sure you pay yourself first so savings and investing are a priority. Yes, it’s costly to wait to invest, but it’s equally costly not maxing out on your investments as early as you can.
Think it through
- How has your mindset changed by learning about compound interest?
- What do you need to change to get compound interest to work (or work harder) for you?
- Who else can you share this message with so they too can benefit from compound interest?
- Learn how to pay yourself first and save more money
- The high cost of waiting to invest – why are you waiting
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