What is Compound Interest?
What is compound interest?
In order to understand compound interest, we have to understand what interest is in the first place. So what is interest? Interest is the money you get back for taking some kind of risk. Most people are familiar with interest because they find themselves on the wrong side of it.
If you've ever bought a house or used a credit card, then you’ve paid someone else interest. They let you borrow some money, and as a result, they charged you for taking on the very real risk that you might not pay it back.
Because you needed to borrow the money, you paid the interest. The bank decided to lend you money because they wanted to collect the interest. It’s the very bedrock of lending.
As you can see, if you are going to take risk, you should be getting paid something in return. It's important to note that risk and reward have a strong correlated relationship. Therefore, generally speaking, the smaller the risk, the smaller the return.
Compound Interest example:
The best terrible idea:
Your bank sends you a shiny new credit card with a $20,000 limit. You spend $10,000 on a super cool vintage pool table, because hey, YOLO! To keep monthly expenses low, you decide to make the minimum payment of $50 per month for that super awesome pool table with LION LEGS, Y'ALL!
$50 per month for 200 months will pay off that pool table, right? And for those 17 years, you will have the coolest game room on earth. What could go wrong?
Compound Interest Strikes Back:
The bank that issued the credit card is charging you 20% annual interest on the balance.
You’re going to have to buy the cheap chalk!
At the end of the first year, your balance should have been $50 * 12 = $600 less than the $10,000 you spent. So the balance owed would be $9,400.
The bank charged you 20% of $9,400, which is $1,880. They added that to your balance of $9,400.
Your new balance is $11,280.
That’s more than the pool table cost in the first place! And you didn’t even get to buy the giant stone leopards to go in the corner!
*This process actually happens each period, but the net result is fairly close, so we’ll leave it simplified for now.
Compound interest can be a very powerful force against you. As a result, if possible, we should be lending the money, not borrowing it.
Is this Investing?
This is one type of investment. All types of investment involve taking on risk and receiving a periodic payment (or the potential for a payment) in return. Investments with compound interest are absolutely the smartest choice, especially for younger investors. Simple interest is better than nothing, but compound interest is the real wealth builder.
Why is compound interest important?
From our waterproof pool table example, we’ve seen how much interest can hurt you. If you’re on the other side of the deal, it can help you build tremendous wealth.
Unless you have the ability (and desire!) to work until the day you die to provide for yourself and your family, you’ll need a way to have your extra money begin to work for you.
Ideally, you put that money out into the world, have it work and live its life, and come back having started a little money-family. If enough money is in your employ, it will begin to generate more than you’re able to take in working on your own.
This allows for that wonderful state of being called retirement.
*As a sidenote, we realize that capital gains and interest are entirely different beasts, but for the purpose of this simplified article, we shall simply call all investment returns “interest.”
How often does interest get calculated?
If you are paying interest, you want it to be calculated as infrequently as possible. On the other hand, if you are earning interest, you want it to be calculated as often as possible.
In most cases, interest is calculated and “accrued” on a monthly basis. In rare cases, annually. Sometimes quarterly. It really depends on the contract and type of debt.
Simple Interest vs Compound Interest
Here’s where the rubber meets the road and how a compound interest investment can help you build a tremendously large legacy to pass on to whomever you choose. For more information on this exact topic, read our post on simple vs compound interest.
For this next example, we’ll assume that we are the lender.
We will buy... a coffee shop!
We lend the local coffee joint $1,000 with the agreement that they will pay us back 5% per year. Simple interest ends there. After 1 year, they owe us $50. In year 2, they owe us another $50. After the third year, they owe us another $50. In year 4, they owe us another $50. And finally, in year 5, they owe us another $50 plus the $1,000 we let them borrow to begin with.
This is annual simple interest, and is exactly how a bond works.
How much did we earn? $250 on our $1,000 loan. 25% over 5 years. In 20 years, we will earn 100% on our original investment.
In a compound interest investment, interest is charged on the principle (initial loan amount) and the accrued interest. Let’s run the numbers again:
2020: $1,000.00 + 5% = $1,050.00
2021: $1,050.00 + 5% = $1,102.50
2022: $1,102.50 + 5% = $1,157.62
2023: $1,157.62 + 5% = $1,215.51
2024: $1,215.51 + 5% = $1,276.28
How much did we earn? 27.6% over the same five years.
That’s not a huge difference…?
Time is your best friend
Push it out 30 years.
Simple interest gets you $1,500 on your $1,000 investment, or 150%. Not bad.
Compound interest gets you $4,321.94. 432% instead of 150%. That’s extraordinarily different!
Push it to 50 years.
Simple interest: $2,500 or 250%
Compound interest: $11,467, or 1,146%
The longer we push the compounding effect out in time, the more extreme the difference gets. Look at 100 years:
Simple Interest: $10,000, or 1,000%
Compound interest: $131,501.25, or 13,150%
This is how family wealth is built and maintained. By compounding returns for a very, very, very long time. This is where the term “multigenerational wealth” comes from.
In the next post, we’ll talk about how to find a good investment with a good rate of return that can help you take full advantage of the phenomenon that is compound interest.