From an early age, we are trained to be skeptical. We were always told that if it sounds too good to be true then it probably is. Compound interest is a definite exception to this rule. Albert Einstein himself declared, “Compound interest is the eighth wonder of the world.”
For those that don’t know, compound interest is the interest you earn on your interest. For example, if you invest $100 in a bond that pays 10% annually, you will receive $10 the first year. If you keep the earned $10 invested, you will receive $11 the second year. If you keep that invested as well you’d receive $12.10 the third year ect… Initially, that might not seem very substantial but if we continued this example for 30 years your initial $100 would have turned into about $1,744 with no work on your part.
The numbers become dramatically more impressive as values increase. Let’s use a fictional character named Jim for this example. Jim is 25 and he has been out of college and working for 3 years now. He has managed to save $10,000 that he wants to invest and figures that he can add $200 a month to his initial investment. If he continued this practice until he was 65 years old(retirement age) he would have slightly more than $608,000. This is assuming he chooses not to add more than $200 every month as his income increased through out his life.
Albert Einstein has also reportedly said about compound interest that “He who understands it, earns it. He who doesn’t, pays it.” This statement rings true when we look at mortgages and how the power of compound interest works against us. Let’s say we get a 30-year mortgage for $200,000 at 3.92% interest rate. Over the course of the 30 years, you will end up paying about $340,000 for your $200,000 house!! To make things even sweeter for the bank that gave you that mortgage, the majority of your monthly payment during the first few years is actually paying for just the interest and not the principal of the loan.
The banks love it when people don’t fully understand these principles because they make a ton of money. It is up to you to educate yourself to make sure you can use use this power to your advantage and not your demise.