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The Basics of Compound Interest

By Edited Apr 28, 2015 0 0

The Power of Starting to Invest When You are Young

Albert Einstein has been quoted, though some believe falsely, as saying that compound interest is "the most powerful force in the universe" or "the greatest mathematical discovery of all time." Whether he said it or not is now almost beside the point, the very fact that people are willing to believe that someone like Einstein, one of the most intelligent men to ever live, did say it speaks for itself. Compounding allows those that are wise enough to start investing early the power to create vast wealth from relatively small amounts of capital. 

Compound Interest

Here is an introduction to how compound interest works. Let's say the bank rate you are able to achieve is a conservative 5% compounded yearly. If you start the year with 1000 dollars, at the end of the year you will have 1000 x 1.05 = 1050 dollars. This extra 50 dollars remains in your bank account, so as you do the same calculation at the end of the next year you have $1050 to calculate the interest with: 1050 x 1.05 = $1102.5. Instead of making 50 dollars like you did the first year, you now made 1102.5 - 1050 = $52.5. Just by letting the money sit, the compounded interest you make each year grow.

An extra $2 isn't a lot of money, but the important part of this equation is time. The compound interest formula is A= P( 1 + i )^N, where A is the amount of money you will have after N amount of years, P is the original investment amount or the principle and i is the interest rate. using the original example of 1000 dollars, let’s take a look at what happens over 10, 20, and 40 years.

For 10 years at 5% A=1000(1+0.05)^10 = $1629

For 20 years at 5% A=1000(1+0.05)^20 = $2653

For 40 Years at 5% A=1000(1+0.05)^40 = $7040

Compound Interest Calculator

Using these three examples it is easy to see the power of time when calculating the profits from compounding. A thousand dollars saved by a 20 year old will be worth over seven thousand by the time they reach retirement age. To put this in perspective, this is saving a little bit over eighty dollars a month for a year to get seven thousand.

No one can retire on $7000, but imagine a person saved 1000 per year every year from the ages of twenty to sixty. A person then need to use the compound interest formula 40 times, with N=40, 39, 38...1. After 40 years, saving a measly eighty dollars a month, a person will have $126840!

Again this is not enough to retire on, but in general as a person ages their income rises and so to should their ability to save. For this calculation let’s say that from 25-30 a person can now save 5000 dollars, from 31-35 7500, from 36-40 10000, and from 41-60 15000. The total amount a person would have by age 60 is an astounding $946929! Almost a million dollars from a relatively conservative savings plan and compound interest rate. We are staring to get close to a good retirment plan here.

Hundred Dollar Bills

I am a new father, and I plan on teaching my son about the compound interest formula very early in life. By instilling this knowledge in him when he is young, I hope to set him up for success later on. I hope by reading this article it will motivate others to do the same.



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