Compound Interest “The Eighth Wonder of the World”
None other than Albert Einstein described this amazing fact about finance, compound interest, as “the Eighth Wonder of the World”.
So, what is compound interest and why is it so important?
Compound interest is, quite literally, a form of free money… and it is free money that grows over and over again. The example detailed below explains how……..
Imagine that you invested €1,000 today and that whatever you invested it in went up by 10% this year. In this case you would have €1,100 one year later, made up from your original sum, plus €100 of interest or return on investment.
Now comes the Compound Interest: Assume you reinvested that €1,100 for another year and achieved 10% again. The following year you would have €1,210. This time you have made €110 of interest simply because the 10% interest is paid on the new balance not the original investment. Essentially, €10 of that interest is free money.
It is the interest you have been paid on your interest or, put another way, the return on your return.
At first glance this may not seem particularly exciting but over time the effect is incredibly powerful. Let’s look more closely at some examples to see just how:
The power of compounding
Let us say you decided to start investing some of your surplus income. For the sake of the argument, you wanted to invest €1,000 each year.
These might seem like numbers to small to make a difference but are they?
The two tables below detail the difference between non compound interest and compound interest.
I have illustrated at 5%, 7% and 9% growth annually, realistic expected rates of return.
These return figures are on top of your original investment !
|Year No.||Annual Invested
||Total Invested||Return 5%
||Total Invested||Return 5%
We can immediately see a meaningful difference between what the saver has managed to achieve after a year versus the investor. Of far more interest is what happens over a number of years.
It is clear to see the big difference between keeping your money in a savings account and investing your money, potentially life changing, even if the amounts you start with are what you describe as “small”. Imagine, the impact can be huge depending on the amount you choose to save.
Just imagine the difference if you were saving €5000 per annum or if you transferred the cash savings you hold now and not later in life.
When Compound Interest works against you…….
It is just as important to understand that if you borrow money, the power of compounding hits you in reverse:
Over time you end up paying more and more to whoever you are borrowing from.
Luke Johnson, the man behind the Pizza Express Chain and ex Chairman of Channel 4 refers to this as “…the gruesome mathematics of leverage in reverse.” This is why you must eliminate debt and get invested as soon as you can. We all know that the majority of debt is expensive. It is challenging to make a 15-20% return on your investments but almost certain you will pay at least this on your debt.
So we can see from the power of compound interest that if you can achieve a half decent return on your money, even a relatively small amount can become a very large amount in time…
This is probably the most important thing you will ever learn about money.