Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it – Albert Einstein
After reading the title of this article, you might be thinking: “Ha! another click-bait article on the internet”. But is that the case in this situation? Well, allow me to explain to you this very simple, yet, incredibly important concept in the investment world. After that, you can judge for yourself if the title was click-baited or not. Let’s begin!
What is Compound Interest?
There are two types of interest, simple and compounded. Simple interest is a fixed amount that you received in a certain period of time based on your beginning account value. Compound interest basically means interest earn on interest over time. In other words, you earn interest on the money you invest and on the interest it generates.
To better understand this concept I’d like to show an example,:
Assuming you start an investment account with $10,000 that pays an average of 6% return per year. If you calculate the interest earned in the first year, $600, you might say it is not that much, but the beauty of this strategy is represented in the later years when your money grows substantially.
As you see above that’s the effect of compound interest over a period of 20 years with a 6% average return per year. It is important for you to know that the values for this example were never altered, in other words, the starting account was $10,000 and the person never contributed more to it.
But what happens if you contribute every month to the account. Let’s take the same example but with the variation that you contributed $6,000 every year ($500 a month) for those 20 years. Let’s see how that account will look like with a conservative 6% return rate.
As you can see with this new example the money earned is way more than what was earned in the first example. With a starting amount of $10,000 and an annual rate of 6% with $500 contributions per month, you could have earned $129,894.24 in interest in a period of 20 years.
It is pretty outstanding how the magic of the compound interest work. In case you want to calculate your own numbers you can visit the Compound Interest Calculator Here!
How does the Rule of 72 take place in the Compound Interest Calculation?
The rule of 72 is simply a calculation used to know how long would it take for a specific amount of money to duplicate using compounding interest. The formula is 72 divided by the interest:
72 / r (rate of return) = x time for investment to double
In the example above you can see different interest rates with the exact time (doubling time) and the approximate time using the quick formula of 72, as you can see the calculations are pretty close so this formula can really help you if you need to do a quick calculation and don’t have a calculator at hand.
You also can use this formula to calculate what rate of return you need to double your money in a specific period of time. For example, let’s say you have $100,000 and you are looking to double it in 5 years.
By applying the rule of 72 you can estimate interest return needed in order to double your money:
72/5 = 14.4% would be the approximate rate of return you will need per year over 5 years to double your money.
3 Ways to Compound Interest
There are multiple ways to invest and get the benefit of compound interest in your investment. However, I’d like to give you 3 basic, yet, really good ideas, that you can use to start earning compound interest today.
This is one of the best ways to earn compound interest since the annual return of the market is around 8-10% average. So using the rule of 72 to you can calculate that, it will take about 9 years to double your money in the stock market (72/8 = 9). However, you have to realize that this is not an exact science, for instance, from 2000 to 2010 the stock market returns were zero, so if you invested in the stock market back then you would’ve had the same amount by 2010.
It is important that you have patience in order to get the best of the compounding interest effect, it is more a long-term concept than a short-term get rich quick scheme.
This is another good way to get the advantage of the compound interest effect, but not in all cases. For this, to work you have to reinvest the interest earned in the same stock everytime they are paid to you. In case you decide not to reinvest in your dividends, you will still earn compound interest but only on the percentage that you earned from the stock, not on the dividends.
A CD is basically a Certificate of Deposit, which allows you to lock-in your money for a period of time to a specific interest rate. Most CDs are giving between 0.5% and 2% over a period of 2 to 5 years. As you might think, it is a very low return, but the only good thing that you can benefit from it is that your principal would be protected against any market downturn and also of course the interest you earn will compound into the future.
here are other investment vehicles that can also help you get compound interest such as a high-interest savings account, real estate, annuities, and bonds.
After reviewing how compound interest works, there is no doubt when saying it is one of the best ways to multiply your money and potentially get rich over time. However, patience is key, the best results are reflected over time, not in the first years. Previously I mentioned some basic ways to generate compound interest but in reality, the best way to grow your capital is to analyze the current market conditions in order to allocate your money in a diversified portfolio with different assets that together could generate you a steady rate of return over the years.
For this we recommend you contact a Certified Financial Planner that can run and analyze your numbers, show you the different scenarios, and then together decide which is the best plan for your situation.