Einstein is frequently misquoted as saying “The most powerful force in the universe is compound interest”. Einstein may not have actually said this but he was well aware of the benefits.
When it comes to successful long-term investing, compound interest is possibly the most important concept you need to understand. Compound interest is when you earn interest on top of interest. For example if you invest $ 1,000 in an account with an average yearly interest rate of 10%. After one year you will have $ 1,100 in the account. Now you would expect that after two years your account value would increase to $ 1,200. However, you would be wrong. The 10% interest is actually applied to the $ 1,100 you have in the account. Therefore, you will actually have $ 1,210 after two years.
Compound interest benefits the long-term investor. Therefore, if you leave that money in an account earning 10% interest each year for 30 years your investment will have grown to $ 17,449. That’s over 17 times more than you physically put in! Try this out for yourself on a compound interest calculator.
If the above figures were not surprising enough, below is how $ 1,000 would grow, if it was saved at different interest rates over different periods of time.
5% interest rate:
5 years = $ 1,276
10 years = $ 1,629
25 years = $ 3,386
50 years = $ 11,468
10% interest rate:
5 years = $ 1,611
10 years = $ 2,594
25 years = $ 10,835
50 years = $ 117,391
15% interest rate:
5 years = $ 2,011
10 years = $ 4,046
25 years = $ 32,919
50 years = $ 1,083,658
The figures above show that over the first 5 years the different interest rates do not create a huge difference in returns. In fact the difference in return between the 5% and 15% interest rate is just $ 735. However, the longer you invest the greater the returns and the greater the effect of the interest rate. So after 50 years the difference in returns between a 5% and a 15% interest rate is over $ 1,000,000! This is the power of compounding.
Now, I bet you’re thinking “That’s great, but no bank account pays a compound interest rate of 10% let alone 15%” and if I had a Dollar for every person that thinks this I would already be a very rich man. The point is yes you will struggle to find a bank account that pays this much interest, therefore you may need to be a bit more creative in what you invest in. To do this I recommend you speak to a qualified financial adviser.
Others may raise the issue of inflation. Inflation can be defined as the gradual rise in prices over time. It is why a Mars Bar now costs $ 1 instead of the 50 cents 15 years ago. Inflation is often overlooked by fans of Compound Interest, perhaps this is because they just want to hear the good news, the fact is though it cannot be ignored and must be taken into account.
So what would have happened to the $ 1,000 example above if we had an interest rate of 10% and an inflation rate of 3.7% (this is the USA 30 year average between 1980 and 2009). The good news is, you would still have $ 17,449 in the account after 30 years. However, in terms of purchasing power it would only buy you the equivalent of $ 5,870 today. This is what economists refer to as the Real Value.
Don’t be disheartened though, $ 5,870 is still nearly 6 times better than $ 1,000. Try it out for yourself on a compound interest calculator.
Finally, I leave you with another possible misquote Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” Einstein. The authenticity might be in doubt but it does sound good.