The Wonders of Compound Interest

Albert Einstein called compound interest “the greatest invention of all time.” It has even been referred to as the “Eighth Wonder of the World.” The trick is to get this tremendous force working for you rather than against you.

Is compound interest gobbling up a significant chunk of your earnings? If you maintain an ongoing balance with a credit card company, compound interest is costing you much more than you probably realize.

Let’s start with basic interest, which is a fee that you pay to a lender for the privilege of borrowing his money. This interest is attached to the original amount at an agreed upon rate. Compound interest is calculated on the balance owing plus any previous interest charges. So then you find yourself paying interest on the interest. This compounding effect continues until it virtually takes on a life of its own. Credit card lenders make a killing putting this principle to work for them. Allow me to illustrate.

Let’s say you’re carrying a balance of $1,000 on a credit card with a 15% APR. If you pay only the minimum each month, you could conceivably gnaw away at this debt for over 25 years and end up repaying a total of over $3,400! If, on the other hand, you could commit yourself to paying $100 per month, this debt would be wiped out in less than a single year and the interest would come to a much less offensive $75.

Now let’s look at what would happen if you took $1,000 and put it to work for you instead of against you. Let’s assume that you are able to keep your hands off this money and simply let it sit and earn 6% interest compounded annually. After 12 years, your money would have doubled without you adding one extra penny!

You can quickly figure out in your head how long it will take for a sum of money to double by applying the “Rule of 72.” You simply take whatever interest rate you’re earning (6% in this case) and divide it into 72. The result will be the number of years required to double your money. (72/6 = 12 in our example)

You can apply the rule backwards as well. Let’s say you have a lump sum of $5,000 that you would like to grow into $10,000 in 8 years. You would need to find an investment that pays 9% compound interest. (72/8 = 9). If the best you can find is an 8% return on your money (hypothetically speaking,) then it would take you 9 years to double your money. Not bad for just letting it sit there!

Now let’s assume that you want to help the growth rate along, so you add an extra hundred dollars to this account just once a year. At the end of the 12 years, you would now have $3,800. If you could discipline yourself enough to add $200 a year, then you would find yourself with almost $5600. Seeing your money grow like this might well entice you to invest more money each month and really reap the benefits of this wealth-generating principle. And there’s more good news. These examples demonstrate what happens when your investment compounds annually. Some institutions are more generous, compounding your interest quarterly, monthly or even daily.

It’s pretty clear which end of the compound interest principle you want to be on. The first step toward the winners’ circle is to pay off your existing debts. Even if you’re already having trouble making ends meet, a mere $1 addition to a minimum payment can significantly shorten the life of that loan. That’s right, just one dollar. You won’t miss it and it would be well worth it. Remember the compounding effect. And once you’re out of debt, there’s no minimum for earning compound interest. Any sum that you can set aside will do. You don’t need to be Donald Trump or Bill Gates in order to benefit from compound interest. It can work wonders for us all.

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