How Compound Interest Works

by mike on December 23, 2011

Don’t worry, this isn’t going to be a long, boring economics class discussion.  My goal is to make this short and sweet.  Understanding the concept of compound interest can literally be the difference between becoming a millionaire or not.  It could mean the difference between retiring with dignity or not.

Here is the main point: if you invest a certain amount of money (called principal), it can earn interest.  The cool thing is that as the money earns interest, both the original principal and the interest it has already earned, earns more interest.  To see how this works, let’s take a look at $1,000 invested today at 10% interest and how much it would be in five years:

 

Year                             Today              Year 1         Year 2       Year 3     Year 4     Year 5

Principal                   $1,000           $1,000        $1,100     $1,210    $1,331     $1,464

Interest                        $0                     $100           $110          $121        $133         $146

Total                           $1,000            $1,100        $1,210      $1,331    $1,464     $1,610

 

So, there you have it.  Investing $1,000 and then doing nothing, it will be $1,610 in just five years at 10% interest.  Let’s expand that a bit to see just how powerful compound interest is.  If you invested the $1,000 at just 20 years old, at age 65 it would be $88,354.  Again, that is adding nothing to it, just letting it ride the compound interest tidal wave!

Here is the moral of the story: start investing now!  The sooner the better.

 

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