Good morning & happy Monday!
Compound interest is the eighth wonder of the world. He who understands it, earns in … he who doesn’t … pays it.
Albert Einstein
Building on last week’s memo on behaving like a saver, today I would like to address the monumental topic of compounding interest. I love this topic!!! I’ve personally seen how it has had tremendous impact (both positive & negative) on a huge percentage of my clients.
Compounding interest is quite simply the idea that interest makes (or is charged) interest.
Let’s look at a couple of examples …
Let’s say I invest $100,000 and make an 8% rate of return (no investment proposal here, just using math). At the end of the first year I have $108,000 (on a calculator $100,000 x 1.08). That’s cool, but the next step is where is starts getting really neat. We start year #2 and I now have $108,000 and make 8% return on that. The easy thought process is to assume I would have $116,000, as I would earn an additional $8,000 in growth like I did in year #1. But, instead I actually make MORE because MY INTEREST IS MAKING INTEREST. On a calculator we start with $108,000 x 1.08 and we get $116,640. That “extra” $640 was the interest I made on my interest earned in year #1. When this keeps compounding it can get INSANE!!! Check this out:
| YEAR | STARTING BALANCE | INTEREST RATE | ENDING BALANCE |
| 1 | $100,000.00 | 8% | $108,000.00 |
| 2 | $108,000.00 | 8% | $116,640.00 |
| 3 | $116,640.00 | 8% | $125,971.20 |
| 4 | $125,971.20 | 8% | $136,048.90 |
| 5 | $136,048.90 | 8% | $146,932.81 |
| 6 | $146,932.81 | 8% | $158,687.43 |
| 7 | $158,687.43 | 8% | $171,382.43 |
| 8 | $171,382.43 | 8% | $185,093.02 |
| 9 | $185,093.02 | 8% | $199,900.46 |
| 10 | $199,900.46 | 8% | $215,892.50 |
By the conclusion of year 10 my $100,000 is worth $215,892.50 … that’s $115,892.50 of growth!
If you keep going along these lines you will find that after 20 years the value of that initial $100,000 is $466,095.71 and after 30 years it’s $1,006,265.69!
Side note: if the parents of a newborn invest $6,000 on the date of his/her birth at an 8% compound interest rate then at age 65 that “child” has over $1,000,000!
See why I get geeked out on this stuff!!! 😉
Holy cow … I think Albert Einstein was right … this seems like the 8th wonder of the world 😊
Now, the 2nd part of that quote is also very true … compound interest can be one of the biggest enemies you ever face … and the price can be severe.
Let’s say I charge $10,000 on a credit card with a 20% interest rate and I pay $200/month ($2,400/year) towards the bill … now compound interest is crushing me. Let’s look at 10 years in this example (slightly overly simplistic math here, but hopefully this illustrates the point):
| YEAR | STARTING BALANCE | INTEREST RATE CHARGED | BALANCE AFTER INTEREST CHARGED | ANNUAL PAYMENT | ENDING BALANCE |
| 1 | $10,000.00 | 20% | $10,200.00 | $2,400.00 | $9,600.00 |
| 2 | $9,600.00 | 20% | $11,520.00 | $2,400.00 | $9,120.00 |
| 3 | $9,120.00 | 20% | $10,944.00 | $2,400.00 | $8,544.00 |
| 4 | $8,544.00 | 20% | $10,252.80 | $2,400.00 | $7,852.80 |
| 5 | $7,852.80 | 20% | $9,423.36 | $2,400.00 | $7,023.36 |
| 6 | $7,023.36 | 20% | $8,428.03 | $2,400.00 | $6,028.03 |
| 7 | $6,028.03 | 20% | $7,233.64 | $2,400.00 | $4,833.64 |
| 8 | $4,833.64 | 20% | $5,800.37 | $2,400.00 | $3,400.37 |
| 9 | $3,400.37 | 20% | $4,080.44 | $2,400.00 | $1,680.44 |
| 10 | $1,680.44 | 20% | $2,016.53 | $2,016.53 | $0.00 |
In this example my total payments were $23,616.53 on a $10,000 starting balance. Ouch! $13,616.53 was my interest cost! See how these credit card companies can make a fortune?!
The big question on this topic becomes … which side of the story are you going to be on when it comes to compound interest. Is compound interest going to be a huge friend or a huge enemy?
If you are directly receiving this email I know that you have made compound interest your friend … but a large percentage of people have not. I would encourage you to forward this email to kids and grandkids … the earlier this lesson can be learned the less costly the bad side of compound interest can be and the sooner the amazing side of compound interest can be realized.
Behave in a way that is consistent with financial success (last week’s memo) and make compound interest your friend and you are building a tremendously solid financial foundation.
It is a tremendous honor to be a part of your life and the story you are writing. Please never hesitate to reach out if we can be of further assistance.