Understanding Compound Interest

11/6/2017

Understanding Compound Interest

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Here's the difference between simple interest and compound interest.

 

Albert Einstein once said “Compound interest is the 8^th wonder of the world.  He who understands it, earns it…he who doesn't, pays it.” So let's see what makes it so great?

Simple Interest

If you put $1,000 dollars in an account earning 5% annually. You will make $50 each and every year. It looks like this.

 

$1,000 plus $50 for the first year and then $50 for the 2^nd year and $50 for the third year. And so on and so on. So in 10 years that $1,000 will have grown to $1,500. That's a 50% increase in 10 years.

But what about compound interest, how is that different?

Compound Interest

Let's take that same $1,000 at 5%, but this time we're going to use compounding interest.

 

So in the first year you earn $50 in interest just like in our simple interest example. But in the second year that interest is added to the original principle amount. So in year two you earn 5% on $1,050 which is $52.50. Now your total is 1,102.50. In year three you earn 5% on this new amount which is 55.13. If we fast forward to the 10 year mark, you will have a total of $1,628.89.

A difference of $128.68 over 10 years is a paltry amount, but this is just a small example.  Let's expand the example to a $10,000 retirement investment over a 40 year working life.  With simple interest, the final sum is $30,000, but with compounding interest the final amount is $70,399.89. That's over $40,000 more.

 

It's important to note that these examples don't include any amounts that you add to your investment over time. The more you add and the more frequently you do so, the more interest you will earn over time.

So, Einstein was a pretty smart guy and knew what he was talking about when he called compound interest the 8^th wonder of the world.

That's this episode of money in minutes. If you have a topic you'd like to hear more about let us know in the comments and don't forget to like and subscribe.

 

 

 

 

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