Hello Friends, I hope all is well with you! I just wanted to thank you all for reading these posts and engaging with me; it really makes my day being able to help someone. I’ve gotten this request multiple times, and it’s rightfully so because this topic is so important. We are going to be covering compound interest and compound growth. They both have the same concept, but I would say that compound growth has a much broader application. I briefly touched on compound interest in A Walk Down Economics Lane, but I wanted to try to go more in depth in this article. Grab your pen and note pad friends, we are about to get started!
As I mentioned in the introduction, I briefly talked about the topic in A Walk Down Economics Lane, but I wanted to go into more detail here. Before I go into compound interest, I wanted to explain simple interest again (I am going to assume you already know what interest is, if you don’t, read my post on economics!). Simple interest is the interest you pay on only the principal balance or the interest you receive on only the principal balance. For example, if I borrowed $1,000 from you and promised to pay you 10% interest in 365 days, I would owe you $100 of interest by the end of that 365 day time period or about $0.27 of interest each day (to get the interest per day, just take the annual interest amount owed and divide it by 365 for the number of days in the year). This is the preferred type of interest to pay when you need to borrow money from the bank for investment properties or your primary home. Mortgages, auto loans, student loans, and personal loans are simple interest loans. You are only going to pay interest on the principal balance, which is way better than paying compound interest on the loans. On the other hand, simple interest is not a wealth accelerator or any type of wealth rocket ship when it is received as a form of investment. Don’t get me wrong, getting income from simple interest is way better than just leaving your money in cash, but it does not have the impact that compounding interest does. Speaking of compound interest, let’s dive into this majestic form of investment.
Compound interest is a beautiful thing; it can create wealth, but at the same time it can destroy your wealth. This type of interest has the potential to be your greatest asset but also your greatest liability. It’s important that you understand what can happen with this depending on what side you stand on. Let’s start by explaining compound interest as your greatest liability. Compound interest, in short, is interest on interest…if that makes sense. Mr. Nahas, what do you mean by that? Great question! In other words, it’s the calculation of the principal and the interest from the previous periods. If it still sounds confusing, I think it would best to explain it by using an example and comparison.
Let’s say that we borrower that $1,000 at a 10% interest rate for 10 years compounded annually. In the simple interest scenario, we would pay $1,000 in principal and the $1,000 in interest for a total of $2,000 at the end of the 10-year time period. In the compound interest scenario, we would pay $1,000 in principal and $1,593.74 in interest for a total cost of $2,593.74 at the end of the 10-year time period. That is a difference of $593.74. You may not think that this is a huge difference, but it will start to be. As we increase the length of time, the greater the difference is, and the greater impact compound interest has. In the three graphs below, you will see the impact that compound interest has at the 10, 20, and 30-year marks. As time passes, compound interest really accelerates and grows exponentially.
Mr. Nahas, how did you do that? Fantastic question! The formula for compound interest is A = P (1 + r/n) ^nt where A is the final amount (principal and interest), P is the principal balance or initial amount, r is the interest rate in decimal form, n is the number of times interest is applied per time period (in other words, it’s how many times it’s compounded), and t is the time period in years. In the example above, n is 1 because we compounded it annually. If we compounded it semi-annually, it would be 2, quarterly would be 4, monthly would be 12, bi-weekly would be 26, weekly would be 52, and daily would be 365. N just depends on how many times interest is compounded in that period. In the example above for 30 years, the formula would be A = $1,000(1+.10/1) ^ (1*30). The more manual way of doing it would be to take the $1,000 and multiply it by 1.1 (remember 1 + the interest rate, which is .10); You get $1,100. Now, do the same thing again using the new number, multiply $1,100 by 1.1; you get $1,210. You would keep doing this for the time period you want.
Now imagine instead of borrowing $1,000, you invested $1,000 at the same terms above. This is what I mean by it’s your greatest asset and your greatest liability. Would you want to pay compound interest or receive it? Obviously, you want to receive compound interest and pay simple interest. The biggest lesson to learn is that compound interest takes patience because it takes time for it to get going to the point where it becomes a wealth rocket ship. I think the most common compound interest investments are index funds, if you don’t know much about index funds, you should read my post on How To Invest In Index Funds. Of course, index funds aren’t the only type of investment that has compound interest, but it’s definitely my favorite and the favorite of many people. It’s also important to mention that credit cards are a type of liability that you pay compound interest on; it’s no wonder why people struggle to get out of credit card debt. If you would like to know some budgeting techniques I use, I encourage you to read my post on How To Budget Effectively. It’s important that you don’t get stuck in the credit card trap. Remember, invest in compound interest, pay on simple interest!
I would say that compound growth is the parent of compound interest; it has a much broader application. You could apply it to real estate investing, to learning new things, to your relationship, etc. It’s all about that “interest on interest” mindset. It’s similar to my post on how Money Trees Actually Exist. It’s about constantly being better than you were yesterday or learning more than what you learned yesterday. For example, reading a book for an hour a day will compound your knowledge over time and after a little while, exponential growth will kick in and next thing you know, you are flying high in the sky. As I mentioned earlier in this paragraph, compound growth can be applied to a variety of things in your life, so it’s important to take advantage of it!
I hope that I provided you with enough information to see the great power of compound interest but also the great liabilities of it. If you have patience and give it time, compound interest and compound growth can really work wonders on your life and finances. Remember, you want to pay simple interest but receive compound interest. If you have any questions or need me to clarify anything, post a comment and I will reach out to you as soon as I can. Thank you, friends, for stopping by! Take care and see you soon!
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