Basic Tips: Compound Interest
I’m happy to introduce my first weekly series: Basic Tips on Personal Finance. In this series I’m going to cover the most basic concepts that one needs to master to learn further personal finance concepts. This week’s concept isn’t the most basic, but is probably the most important to long term wealth building: Compound interest. It’s actually a pretty simple concept once you understand how it works- and how it can work for you.
So let’s get hypothetical. Imagine you’ve got $100 to save. So you put it into, say, a savings account at your bank. For the example’s sake, let’s say that this savings account pays out 5% interest per year. It’s very rare that a savings account will earn that, but the number is easy to work with. Now you do one of the most vital things involved in saving: you keep your hands off the money so that it sits there and earns interest. After a year the monthly interest has come to a total of $5, which is 5% of $100. You now have $105.
But wait! The really cool part is coming next. Now you leave that $105 in the account for another year. At the end of Year 2 your earned interest of 5% of $105 is $5.25. You now have $110.25!
Okay…now stop giving me that look. It’s true that $10.25 isn’t much to show for two years of waiting, and that extra $0.25 is pretty underwhelming. But don’t underestimate what just happened. Let’s change the numbers by adding a few zeros. You invested $1,000,000 rather than $100, so that first year’s interest was $50,000. Not bad. Year 2’s interest is pretty neat, too: $52,500.
So the idea is this: compound interest is the idea that the interest you earned last year and before becomes part of the original chunk of money, so it earns interest too. You can earn interest on the interest from the interest of two years ago. Neat!
Hope that helps someone. Thanks for reading,