Albert Einstein was a pretty smart guy, right? 🤓 He once described compounding interest as the “eighth wonder of the world.” He knew that when it comes to your financial health, compounding interest could be your best friend…or your worst nightmare. 😱
Here are Five Fast Facts on compounding interest:
- ❄️ What Is It? When you make an investment, you expect to receive your original amount (the principal) back, plus a little more (the interest). Compounding interest is when you earn interest on the interest you’ve already earned. It’s like a snowball picking up additional snow as it rolls downhill.
- ⏳ It’s A Period Thing - One of the keys to understand is that compounding interest really becomes powerful as time goes on. Different investments compound interest for different periods of time, but it’s usually daily, monthly, or annually. Whatever the period is, the more periods there are to compound, the more powerful the effect is. Time is your friend here! Even small amounts over a long period of time will give you HUGE benefits. How huge? Glad you asked…
- 📈 Example, Please! Let’s say you start investing $100 per month in the market when in your 20s, and let’s assume you earn 12% annual interest on that investment, compounded monthly, for the next 40 years. Now let’s say a friend of yours starts investing 30 years later than you do, and invests $1k per month for 10 years, with the same annual interest rate. Your friend has invested $120k and will end up with $230k in savings. You, on the other hand, have invested only $48k and will have almost $1.2 million in the bank! Got your attention now, right? The key: START EARLY!
- 💰💸 How Exactly Does This Black Magic Work? It’s actually pretty simple. To keep the numbers easy, let’s say you invest $10k for three years, earning 10% interest each year. At the end of the first year you’ll earn $1k, for a total savings of $11k. At the end of the second year, you’ll earn another 10% interest on your original amount ($10k, the principal), but also on the interest earned in year 1 (the extra $1k). So, at the end of year two you’ll earn $1,100, for a total savings of $12,100. Same thing happens in year three, so you’ll earn $1,210 for a total savings of $13,310. You can now see that the longer this cycle goes on, the more “free” money you earn through the power of compounding interest! Fire up the cauldron, this is a magnificent money potion!
- 🏦 Look At The Experts - You would think that banks have a better understanding of this principle than pretty much anyone else, right? Right-o! They use compounding interest on YOUR money to make THEMSELVES money. It’s no coincidence that five of the ten most profitable companies in the world are banks!
🔥Bottom line: This all sounds great, but what’s the nightmare side of this magic? Well, compounding interest works for you when it’s investing…but against you when it’s debt. When you’re paying interest on credit cards, loans, or other debts, this black magic is like the love child of a Dementer 👻 and the Cocaine Bear 🐻 - you do NOT want it coming after you!
Compounding interest is a very powerful tool when it comes to finances. Fortunately, it’s not hard to understand. Whether you’re getting out of debt or building for the future, make sure you understand the terms and how it impacts you at each step of your journey. Use that “eighth wonder of the world” to inject some magic into your life!
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