Throughout time one of the key strategies to build and maintain ones wealth has been investment. Very few that are wealthy and have gained some form of wealth have done it through solely earning an income. And the goal of building wealth lead me to the concept and strategy of compounding interest. By nature I’ve been very good with the coin, and have overtime become even better at managing my money. Investing however, has been a different game entirely and has not been part of my early education.
This simple article will show you the long-term potential and power of compounding interest. While allowing you to think more broadly about the topic and also the impact of compounding in general. See compounding can be applicable in anything; you could be 1% healthier a week, 1% more skilled in your profession or chosen field. Over time, these increases add up and compound to something noticeable. But let us look at it through a financial lens for now.
A Simple Interest Example
Let’s say the current interest rate is 6%. Your bank is offering a 6.4% pa interest on its savings account. Well if you deposit your $2,000 into that account for one year. You will earn $128 on that initial amount.
Compounding Interest takes effect when that initial $2000 that you put into the bank is combined with the earnings you made through the investment. So now imagine if you applied that same interest rate of 6.4% pa to $2128. You would have $136.19 the next year. Which would then earn you $144.90 the year after. And in three years time you’re account is sitting at $2,409.09. Which is $409.09 more than the initial investment of $2000.
$409.09 isn’t all that much in the grand scheme of things. However, if you look at it from another perspective. $409.09 is almost 1/4 of the original sum of $2000. So essentially in three years, we earned almost 1/4 of our original investment at the modest rate of 6.4% pa. Now if you had $400,000 instead of the original $2000. You would be sitting on $81,820 from three years on that investment.
Of course it isn’t always that simple. Getting such a large sum, finding a bank saving account with such a rate, especially during low economical periods is challenging. But there are other investment paths that you can take, which provide you with consistent and overall safe results. During university, I had saved up $9,000 and the interest rate at the time was 8.00% pa, earning me a nice little chunk of change. But I had no idea what I was doing back then.
Compound Interest Formula
FV being future value, PV being present value. Where i is interest rate and t is the time period, depending on the investment type.
FV = PV(1+i)^t
FV = 2000(1+.064)^3
Where the Real Magic Happens
What if every period you can invest and additional $2000? By the second year you have 2000 + 2000 + 136.19 = $4,136.19 @ 6.4% pa you would have earned yourself $264.71 instead. Now imagine if you were able to continue to add to this investment every year for 10 to 20 years. That’s where the real magic happens and that is where you can make leaps that were previously unimaginable.
Alternatively increase the time period to say 40 years. Starting at our favorite sum of 400k @ 8.00% pa (high, but not too high). It can even be a collective family fund. We are sitting on $8,689,808 in 40 years time. Yes ladies and gentlemen, $8.689 million. And there you have it.
The real challenge is finding the appropriate invest type and returns.