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Baby Step #4 - "The most powerful force in the universe is compound interest" -Albert Einstein
How simple and compounding interest impacts your wealth
Do you remember tuning out in business class when your teacher was giving you the basic information on how interest rates affect our loans and investments? Now it’s time to re-evaluate what we’ve all ready learned but failed to truly appreciate because we were pre-occupied with calculating our Friday night soiree instead of our math equations. Let's revisit some basics to learn small ways on how to let our money work for us, starting with a look at simple interest.
Formula for Simple Interest:
Interest= Principle, Rate & Time
I = P x R x T
Let’s say I take the grant money I've just received, (for the sake of exemplifying, a $1,000 deposit) and open an online savings account with a 5% interest rate. After one year, this is how my balance would look:
$1,000 (the principle, or my initial investment) x 5% x 1 year
$1,000 x .05 x 1 = $50
Therefore, after one year, my $1,000 investment has grown into $1,050 by allowing it to sit quietly in the bank.
Now, let’s look at how both compounding interest and time can help fatten that amount substantially.
The first year, simple interest is added onto my starting principle (being the initial deposit of $1,000). The second year, new interest is calculated on my starting principle of $1,000, as well as on the interest I’ve accumulated (in this case, the $50). This is the appeal of compound interest, or interest being applied to interest. It works beautifully over time, thus making it a powerful and effective means to nurture long-term investment growth.
If I invested $1,000 today at a consistent 5% and let it sit for 40 years without putting my little paws on it or investing another penny into that account, my final amount, after 40 years with compound interest, would be $7,039.99 That’s an incredible leap for a mere $1,000.
If I invested $1,000 in an online savings account, at 5% fixed rate, and continually add $1,000 to the account every year thereafter; after 40 years, by faithfully adding $1,000 each year, compound interest morphs my total investment of $40,000 (or $1,000 x 40 years) into a whopping $133,879.75!
When compound interest works it's enchantment hand in hand with time, things get a whole lot niftier for investments which are allowed to sprout over the course of several decades. If a 25 year-old diligently saved $20 a week for 40 years in a checking account, they would amass approximately $38,400 by the time they retired. If that same person allowed compound interest to work for their money and invested $20 a week into an account earning upwards of 12% interest, he or she would be a gloating, filthy-rich millionaire by 65.
Compound interest, through the imperative use of time, is wisely allowing money to yield long-term financial goals. It is also why it is so crucial for young people to start investing what they can now, while time is in their favor.
** Baby step #4 (addendum) – For my fellow broke-ass students; Remember, it’s not necessarily how much income we have, but rather how wisely we're able to utilize our current income stream. You’ll be amazed how much even small, diligently-made contributions can amass over time.
Let’s say you sock away $5 a week, or $20 per month, in your underwear drawer. After one year, your total will be around $240. If you continue to sacrifice spending enough to dedicate $5 a week to stuff in your old tattered undies, after 40 years you’ll have roughly $9,600 stashed at home.
Now let’s make that money work for you more, and invest that $5 a week (or $20 per month) in a type of savings account with a fixed 5% yearly interest rate. With the magic of compound interest at work, by contributing $5 a week, after one year at 5%, your $240 would equal around $252. After 40 years of compound interest, that $9,600 from above would morph into a juicy $32,131.14.
Definitely not bad for some pocket change, eh? :) No amount is too trivial to begin venturing down the path of wiser financial strategies.
~†~ Baby Steps are Key ~†~
