“Compound interest is the eighth wonder of the world. He who understands it earns it… he who doesn’t… pays it.”Albert Einstein
Consider the above statement carefully. It would be a lot better to be on the earning side, which is also, the understanding side. Your millionaire neighbor is not necessarily smarter, or a hard worker or a gambler. They understand the eighth wonder of the world – the power of compounding and put it to use for themselves.
In simple terms, compound interest is when the interest on your principal amount starts earning interest. In other words, it is interest on interest.
For example, if you have a saving account with Rs 100 in it and in the first year you earn an interest of 7% on it. At the end of the first year you would earn Rs 7 and have Rs 107 as your closing balance. However at the end of the second year, you would be earning interest on Rs 107 and not on the initial Rs 100. At 7%, that amount would be Rs 7.49 and therefore your closing balance would be Rs 114.49. The extra 0.49 is compound interest. Doesn’t seem much, does it?
For large amounts and for large periods, this addition is very significant. It can make you a millionaire.
There are two major factors that influence compound interest earnings. They are interest rate and time.
There is not much you can do about the interest rate but time is under your control. That is why it is critical to start investing early in life and stay invested for a long period of time.
Check out how Dave Ramsey explains compound interest and the power of compounding.
Rule of 72
- A simple “rule of thumb” for calculating how much time it takes for your investment to double is called the “Rule of 72″.
- Divide 72 by the interest rate. The answer will give you the number of years it will take for your money to double.
- So at 7% interest rate, it will take 72 / 7 = 10 years for your money to double.
- So if you continue investing at 7% for 30 years, your money will be 8 times the original investment at the end of 30 years.
Of course, this is not immediate. Anything worth achieving requires hard work and patience.
Read more on Long Term Investing.
Use the compound interest calculator below, to try this out.