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If you're like me, starting out trying to learn compound interest was exhausting. Even thinking about it made me tired. All I knew was Einstein said compound interest is the eighth wonder of the world…Just kidding, that's an urban legend apparently. But you get the idea of how important people make compound interest out to be.
Luckily for me, in high school, we learned in-depth what simple and compound interest were and how it can be applied to real life situations so I was really prepared…See, I've got jokes. I'm here all week.
All we did was spend two lousy weeks on what the difference between simple and compound interest was, and that was it. Looking back, I'm like are you kidding me?? Other than the occasional algebra I use once in a blue moon at my job, this is the one topic I needed my math teachers to come through on, and they bombed miserably.
Like, guys, you're costing me millions here, come on.
I began my search on the internet to find out what this compound interest would be able to do for me. The only problem was, no matter what I tried typing into Google, I kept getting links to complicated ways of explaining this stuff.
It was like all these pages lost all perspective what it was like to get started. I literally didn't know what the difference between simple and compound interest was. I found this chart online:
And proceeded to almost give up before I even really tried. It looked ridiculous to me. All these formulas and letters and numbers just to get what I thought was a simple answer to how much an investment would be worth down the line. Luckily, we don't have to actually do that. We can just use a compound interest calculator. My favorite calculator for that is in my recommendations page on the bottom.
Before I even get into compound interest, let's start with the basics:
What is simple interest?
Simple interest is a fast way of calculating the interest charge on a loan. The formula for simple interest is multiplying the principle (investment) by the interest rate by the number of days (Simple interest=principle x rate x days). In most cases, this applies to auto loans or short-term loans.
On a simple interest payment, the money first goes into that month's interest, and then the remainder of the principal, or original investment amount.
What is compound interest?
Compound interest is a little different. The interest is determined by the initial principle as well as the accrued interest on the previous periods. Basically, it is interest on interest. Did I lose you yet? Yea, my head was spinning at this point too.
Compound interest is calculated by multiplying the principal amount by 1 plus the interest rate. So really what that means is if a $5,000 investment received a 10% rate of performance for the year, to find the total amount made from the $5,000 you would do the following: $5,000 x (1+.1) which equals $5,500. The 1 is added because that represents 100% or the original investment of $5,000, so you are adding the .1 or 10% performance rate of the investment onto that initial amount.
Where simple and compound interest differs is the next step. Simple interest would continually base the interest off of the $5,000 or however much is remaining. With compound interest, you are starting the next period at $5,500. You get interested on the interest from previous years! See how nice that is? All you had to do was invest the initial amount and let it sit there. This is you while you're getting that money:
If you want a great video for an introduction, Kahn Academy's Introduction to Compound Interest was where I first started.
They start from the very basics explaining compound interest as if you are five years old (in a good way). It was super helpful in giving me the confidence to begin my journey to learn the ins and outs of compound interest and how it relates to investing, and most importantly, retirement.
Remember this: the #1 mistake costing young people millions in their career is not putting in the time to learn about compound interest and how it affects their net worth and retirement life.
Taking care of your net worth is like taking care of your lawn: nobody is going to be as careful and put as much effort to make it look nice as you will. That's just the way it is. You need to invest the time. I don't care if it's during your commute to work, 20 minutes before or after you get home from work, 20 minutes on the weekend, whatever. Just do yourself a favor and look out for your 65-year-old self. That person will thank you when you've retired drinking margaritas on the beach.
Why does compound interest matter for investing?
I'll tell you why, because it's awesome. And it's never too early to start! Even if you have $10 left over from your paycheck and you think it won't make a difference, it will:
$10 each paycheck invested at the average market return at 7% turns into $79,705.48. Now I know you have more than $10 to invest even if you don't believe it, but that's for another post.
Just take a look at the effect compound interest has in this chart. This is the difference between a person who puts $200 per month (in most cases that's only $100 a paycheck) into a retirement account with an estimated 6% rate of return starting at the age of 25 vs. someone who does the same, but begins 10 years later. By the time they are 65, the first person invested a total of $96,000 while the second person contributed $72,000. You might be thinking oh yea, a $24,000 difference ooooh wow. But actually here's the real difference:
$402,492 vs $203,118. And they weren't even saving a tremendous amount. Imagine the possibilities when you start early and save more than you think you can. Here is another chart for you showing how much you need to save monthly at ages 20, 25, 30, etc. to get to $1 million:
That's really not bad at all. $500 a month. I live in New York City and can find a way to scrape up $500 each month for my retirement.
You really need to start thinking about investing for retirement as soon as you get a full-time job. I know it seems so far away, but the effects compound interest can have on your money works wonders if you take advantage of it.
Feel free to leave comments below on your thoughts and what your experiences have been like, I'd love to hear from you!
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